What Predetermined Overhead Rate Is Formula and Sample

At the end of the accounting period, the actual indirect cost is obtained and compared with the absorbed indirect. Using the planned annual amounts for the upcoming year reduces the fluctuations that would occur if monthly rates were used. Hence, the overhead incurred in the actual production process will differ from this estimate.

• Manufacturing overhead is allocated to products for various reasons including compliance with U.S. accounting principles and income tax regulations.
• The predetermined overhead rate is calculated by dividing the estimated manufacturing overhead by the estimated activity base (direct labor hours, direct labor dollars, or machine hours).
• The second step is to estimate the total manufacturing cost at that level of activity.
• The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed.
• Further, overhead estimation is useful in incorporating seasonal variation and estimate the cost at the start of the project.

Keep in mind that your predetermined overhead rate is just an estimate – it’s not set in stone. As your business grows and changes, you may need to adjust your rate accordingly. A manufacturer producing a variety of products that require different processes will have multiple overhead rates known as departmental overhead rates instead of just one plant-wide overhead rate.

What are some concerns surrounding the use of a predetermined overhead rate?

The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed. For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients. Based on the manufacturing process, it is also easy to determine the direct labor cost.

This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year. Figure 4.18 shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl.

It is very important to understand the purpose for which the predetermined overhead is being used. If we prepare the cost sheet for a year or a longer period, it is appropriate to include the fixed cost in overhead allocation. However, if we have to submit a quote for a one-time order which is not recurring and the organizations have already recovered the Fixed cost from the current contribution. Overhead expenses are generally fixed costs, meaning they’re incurred whether or not a factory produces a single item or a retail store sells a single product. Fixed costs would include building or office space rent, utilities, insurance, supplies, maintenance, and repair. Unless a cost can be directly attributable to a specific revenue-generating product or service, it will be classified as overhead, or as an indirect expense.

Overhead Rate Formula and Calculation

Predetermined overhead rate is the estimated overhead that will allocate to each product at the begining of accounting period. It is equal to the estimate overhead divided by the estimate production quantity. Let’s say there is a company, ABC Ltd., which uses Labour Hours as the base for allocating Overheads. In the coming year, the company expects the total overheads to be $150,000 and expects that there will be 3,000 direct labor hours worked. The predetermined overhead rate helps prepare budgeted costs for each department. After the actual numbers are out, comparing actual and budgeted numbers helps identify variances and the factors driving them.

On the other hand, the machine hours were used to absorb overheads in a machine incentive environment. For instance, it has been the traditional practice to absorb overheads based on a single base. For instance, a business with a labor incentive environment absorbs the overhead cost with the labor hours. On the other hand, the business with the machine incentive environment absorbs overhead based on the machine hours. That amount is added to the cost of the job, and the amount in the manufacturing overhead account is reduced by the same amount.

Monitoring relative expenses

A predetermined overhead rate is an allocation rate given for indirect manufacturing costs that are involved in the production of a product (or several products). In order to find the overhead rate we will use the same basis that we have chosen by multiplying this basis by the calculated rate. For example, if we choose the labor hours to be the basis then we will multiply the rate by the direct labor hours in each task during the manufacturing process. In larger companies, each department in which different production processes take place usually computes its own predetermined overhead rate. Second, if the underlying assumptions change (e.g., the expected level of activity), the rates will no longer be accurate and will need to be recalculated. Finally, predetermined overhead rates can be difficult to update on a regular basis, which can lead to outdated information being used in decision-making.

So, the cost of a product in one period may not reflect the cost in another period—for instance, the cost of freezing fish increases in the summer and lowers in the winter. However, there is a strong need to constantly update the production level depending on the seasonal fluctuations and the factor affecting the demand of the product. Also, if the rates determined are nowhere close to being accurate, what are dividends how do they work the decisions based on those rates will be inaccurate, too. The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved. The difference between the actual and predetermined amounts of overhead could be charged to expense in the current period, which may create a material change in the amount of profit and inventory asset reported.

Introduction to Predetermined Overhead Rate

The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed. In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation. The most prominent concern of this rate is that it is not realistic being that it is based on estimates.

How to Calculate Predetermined Overhead Rate?

Take, for instance, a manufacturing company that produces gadgets; the production process of the gadgets would require raw material inputs and direct labor. These two factors would definitely make up part of the cost of producing each gadget. Of course, management also has to price the product to cover the direct costs involved in the production, including direct labor, electricity, and raw materials. A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability. The overhead rate has limitations when applying it to companies that have few overhead costs or when their costs are mostly tied to production. Also, it’s important to compare the overhead rate to companies within the same industry.

Using the predetermined overhead rate formula and calculation provides businesses with a percentage they can monitor on a quarterly, monthly, or even weekly basis. Businesses monitor relative expenses by having an idea of the amount of base and expense that is being proportionate to each other. This can help to keep costs in check and to know when to cut back on spending in order to stay on budget. The company, having calculated its overhead costs as $20 per labor hour, now has a baseline cost-per-hour figure that it can use to appropriately charge its customers for labor and earn a profit. That is, the company is now aware that a 5-hour job, for instance, will have an estimated overhead cost of $100. Now management can estimate how much overhead will be required for upcoming work or even competitive bids.

Departmental overhead rates are needed because different processes are involved in production that take place in different departments. Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour. Therefore, the predetermined overhead rate of TYC Ltd for the upcoming year is expected to be $320 per hour. Hence, you can apply this predetermined overhead rate of 66.47 to the pricing of the new product X. Therefore, this predetermined overhead rate of 250 is used in the pricing of the new product.

One of the advantages of predetermined overhead rate is that businesses can use it to help with closing their books more quickly. This is because using this rate allows them to avoid compiling actual overhead costs as part of their closing process. Nonetheless, it is still essential for businesses to reconcile the difference between the actual overhead and the estimated overhead at the end of their fiscal year.