 Product costs are the total of direct materials, direct labor, and indirect manufacturing overhead. Recall that direct costs, like direct materials and direct labor, are traced to the 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 the departmental 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 the labor cost to directly assemble or manufacture the products. Manufacturing overhead is slightly more complicated. In short, it is all the costs in 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 the plant-wide rate method does not do a good job of matching costs of overhead resources with the products. Additionally, more simple allocation systems result in over costing or under costing their products. This is commonly referred to as cost distortion. So rather than have one pool of overhead to allocate with a plant-wide rate, we can refine the process by breaking out overhead by departments. Departments can be actual departments or product lines or products like I've shown here. Once overhead has been divided into departments, the process is similar to the predetermined overhead rate. We estimate the overhead by department and divide that by the department's allocation base. So let's look at an example of a dairy plant. A dairy plant estimates its overhead by department and assumes the following. Half gallons, one million dollars, gallons, one and a half million dollars. It allocates overhead with departmental rates using direct labor hours as the allocation basis for half gallons and machine hours for the more automated gallon production. Notice that the more refined system can use different allocation basis for different departments. So let's assume the following. The half gallons have estimated to have 80,000 direct labor hours and the gallons are estimated to have 150,000 machine hours. We can see that half gallons will be allocated $12.50 of overhead per direct labor hour. For each direct labor hour used to manufacture milk, $12.50 of overhead will be allocated. If the plant produces 1,000 half gallons per hour, then each half gallon will be allocated one and a quarter cents of overhead. The gallons will be allocated $10 of overhead per machine hour. For each machine hour used to manufacture milk, $10 of overhead will be allocated. If the plant can produce 2,500 gallons per hour, then each gallon will be allocated .004 cents of overhead.