If all production departments in a manufacturing business have the same mix of labour and machines, and all jobs require the same amount of work in a given department, then it is appropriate to use a single, plant-wide overhead rate.
However, if some departments are machine intensive and some are labour intensive, then the amount of overhead applied will not approximate the overhead used in all departments. If we use DLH’s as the activity base in a labour intensive department, this will give a good result but if we use DLH’s in a machine intensive environment that has few labour hours actually worked, the result will be very unsatisfactory. Machine-intensive departments typically use a lot of overhead cost but if there are few labour hours and the rate is applied on the basis of DLH’s, little overhead will be applied.
Even if all departments are labour intensive, the amount of labour time required for each job might vary from one department to another. This could still result in imprecise application of overhead costs to a given job if a single labour based plant-wide rate was used for all departments..
To overcome these problems companies use multiple overhead rates. Machine intensive departments have their own overhead cost pool and the rate is based on Machine hours. Labour intensive departments likewise have their own cost pool based on DLH’s or Direct Labour $. If the labour time varies from job to job in an given labour-intensive department, then each department should still have its own overhead cost pool and MO rate based on a labour activity base just for that department.
By using separate departmental overhead rates, the overhead applied can be tailored to the specific needs of a particular job. This will lead to more precise costing of products, which can be critical if the business has to bid for jobs.