Upon allocating all support service costs to producing departments, an overhead rate can be computed for each department. This rate is computed by adding the allocated service costs to the overhead costs that are directly traceable to the producing department and dividing this total by some measure of activity, such as direct labor hours or machine hours. For example, from Exhibit 7-10, the total overhead costs for the grinding department after allocation of support service costs are $355,000. Assume that machine hours are the base for assigning overhead costs to products passing through the grinding department and that the normal level of activity is 71,000 machine hours. The overhead rate for the grinding department is computed as follows:
Using these rates, the product’s unit cost can be determined. To illustrate, suppose a product requires two machine hours of grinding per unit produced and one hour of assembly. The overhead cost assigned to one unit of this product would be $12 [(2 x $5) + (1 x$2)]. If the same product uses $15 of materials and $6 of labor (totalled from grinding and assembly), then its unit cost is $33 ($12 + $15 + $6).
One might wonder, however, just how accurate this $33 cost is. Is this amount really what it costs to produce the product in question? Since materials and labor are directly traceable to products, the accuracy of product costs depends largely on the accuracy of the assignment of overhead costs. This in turn depends on the degree of correlation between the factors used to allocate support service costs to departments and the factors used to allocate the department’s overhead costs to the products. For example, if power costs are highly correlated with kilowatt-hours and machine hours are highly correlated with a product’s consumption of the grinding department’s overhead costs, then we can have some confidence that the $5 overhead rate accurately assigns costs to individual products. However, if the allocation of support service costs to the grinding department or the use of machine hours is faulty or both then product costs will be distorted. The same reasoning can be applied to the assembly department. To ensure accurate product costs, great care should be used in identifying and using causal factors for both stages of overhead assignment.
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