Using a plant-wide rate is logical when there is one root cause of the indirect production costs and the company manufactures similar products. For example, a company with a simple manufacturing operation that produces similar products could have a plant-wide overhead rate of $40 per machine hour if it has budgeted $800,000 of total manufacturing overhead costs and it expects to produce 20,000 machine hours of good output.
On the other hand, if the company manufactures diverse products, some of which use expensive equipment while some use only inexpensive equipment, a plant-wide rate is not appropriate. In response to this situation, manufacturers have developed departmental overhead rates. Thus, only the products that use the expensive equipment in a specific department will be assigned a higher overhead rate of perhaps $70 per departmental machine hour. The products requiring a simpler operation such as assembling may be assigned overhead at a rate of perhaps $20 per direct labor hour.
Some companies have moved beyond both the plant-wide rate and the departmental rates because they want to consider all of the activities that are driving up manufacturing overhead costs. These companies are attempting to find the root causes of the indirect manufacturing costs so they can assign the costs to products in a more logical manner (instead of merely spreading the costs arbitrarily via plant-wide or departmental production hours). This effort is known as activity based costing.
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