 Product costs are the total direct materials, direct labor, and indirect manufacturing overhead. Recall that direct costs, like direct materials and direct labor, are traced to finished product, whereas indirect costs, like manufacturing overhead, are allocated to the finished product. There are three common ways to allocate manufacturing overhead to products. The most common is the plant-wide rate. This is what we earlier described as the predetermined overhead rate. Another method is departmental rates. Finally, the most refined method is activity-based costing. This video will focus on activity-based rate method. Direct materials is a concept most understood because they end up in the product or product packaging. Direct labor is also fairly understandable because it's a labor cost used to directly assemble and manufacture the products. Manufacturing overhead is slightly more complicated. In short, it is all the costs of a manufacturing plant that aren't either direct materials or direct labor. Examples include depreciation, utilities, maintenance, supplies, insurance, and indirect labor, like supervision, setup, cleanup, and testing. Many companies choose to refine or improve their method of overhead allocation to try to achieve more accurate product costs. This is because plant-wide rate method does not do a good job of matching the cost of overhead resources to the products. Additionally, more simple allocation systems result in over-costing or under-costing their products. We call this cost distortion. So rather than have one pool of overhead to allocate with a plant-wide rate, we can refine this process by breaking out overhead by departments. Departments can be actual departments like departments or product lines or products, like I've shown here. But even departmental rates aren't refined as much as activity-based rates. With activity-based rates, we divide manufacturing overhead into groupings of activities. Ideally, these are the activities which cause the business to incur overhead costs in the first place. You can see in my example the activities are machine setup, milk processing, filling, and packaging and labeling. So when determining overhead cost allocation with activity-based rates, the first step is to identify the activities and how much overhead is related to each one. Notice that the total of the overhead is still $2.5 million. This is the same amount we allocated with the plant-wide rate and the departmental rates. The next step is to identify the cost driver of overhead and estimate the number of activities that will occur for the period. A cost driver is the activity that most likely caused the overhead to occur for that function. As you can see here, the number of times the machine needs to be set up is the cost driver for the overhead associated with the setup activity. The third step is to calculate the overhead allocation rate for each activity. If you want to think of this as a predetermined overhead rate for each activity, that's perfectly fine because that's what we're doing. So the estimated overhead cost per activity divided by the estimated number of cost driver activities equals the overhead allocation rate per activity. Another way to look at the third step is to put the information in a table like I've shown here. Then we can enter the actual number of activities used by a certain product or product line. The fifth step is to allocate overhead to products based on the amount of activity they have used. For example, products that have used more packaging and labeling activity will be allocated more of the overhead from that function. In this example, gallons of milk are allocated 1,770,000 of the 2.5 million in overhead. Assuming we manufactured 10 million gallons, then each gallon of milk would be allocated 17.7 cents of overhead. We would repeat steps 4 and 5 for our other products. In this case, these numbers are assumed to be the usage for half gallons. Notice the activity cost allocation rates don't change. The only thing that changes is how much each activity is being used to manufacture half gallons of milk. Once we complete the table, we can see that half gallons were allocated 730,000 of the 2.5 million of overhead. Assuming we manufactured 2 million gallons, then each half gallon of milk would be allocated 36.5 cents of overhead. This is one of the reasons why half gallons are more than 50% the cost of a gallon of milk. So with a more refined overhead allocation method, you can see that gallons end up being allocated more overhead than with a less refined method. This means that using a plant-wide rate or departmental rates, we've over-costed half gallons and under-costed gallons.