To illustrate, let's assume that a manufacturer has three operations with each occurring in a separate department:
- Dept #1 uses a large, sophisticated machine having a cost of $900,000
- Dept #2 uses a small $40,000 machine to refine the products coming out of Dept #1
- Dept #3 is an additional, optional process that uses a $10,000 machine
When the manufacturer divided its total manufacturing overhead for the upcoming year by the total machine hours for the upcoming year, the result was a plant-wide overhead rate of $30. If Product A requires 7 hours in Dept #1 and 1 hour in Dept #2, it will be assigned overhead of $240 [(7+1)X$30]. If Product B requires 2 hours in Dept #1, 2 hours in Dept #2, and 4 hours in Dept #3, it will also be assigned overhead of $240 [(2+2+4)X$30].
When departmental overhead rates were computed, the manufacturing overhead rate for Dept #1 was $50 per machine hour (resulting from high amounts of depreciation, electricity, maintenance, etc.). The overhead rate per machine hour for Dept #2 was $20, and $15 for Dept #3. Using the more accurate departmental overhead rates Product A will be assigned overhead of $370 [(7X$50)+(1X$20)]. Product B will be assigned overhead of $200 [(2X$50)+(2X$20)+(4X$15)].
Having multiple, departmental overhead rates will better reflect the costs of manufacturing Product A and Product B compared to using a single, plant-wide overhead rate.