Predetermined Overhead Rate
A predetermined overhead rate is a rate used to apply manufacturing overhead to products or job orders and is established before a period begins. This rate is calculated by dividing the estimated manufacturing overhead cost for a period by the estimated total units in the allocation base for that same period.
The predetermined overhead rate is used to allocate or apply overhead costs to the cost objects, like products or job orders, during the period. This is necessary because overhead costs are not directly traced to individual products or services but still form a significant part of the total production cost.
The formula for calculating the predetermined overhead rate is:
Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Activity Base
Here,
- The Estimated Overhead Costs are the total indirect costs that are estimated to be incurred during a certain period.
- The Estimated Activity Base could be estimated direct labor hours, machine hours, direct labor cost, or any other cost driver that’s relevant to the company’s operations.
It’s important to note that this is an estimated rate, and actual overhead costs and the actual activity base can be different from the estimated figures. Therefore, at the end of the period, there might be an underapplied or overapplied overhead, which must be adjusted.
Example of a Predetermined Overhead Rate
Imagine you run a small furniture manufacturing company. Before the start of the year, you calculate your total estimated manufacturing overhead costs. These might include things like indirect labor, indirect materials, utilities, rent, and depreciation on your factory machines – costs which are difficult to attribute directly to individual products.
Let’s say these estimated overhead costs for the upcoming year are $500,000.
Next, you choose an allocation base. For many companies, this is often something like direct labor hours or machine hours. In your furniture company, let’s say you expect to use 20,000 machine hours this year.
Using these two figures, you can calculate your predetermined overhead rate:
Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Activity Base
Predetermined Overhead Rate = $500,000 / 20,000 machine hours
Predetermined Overhead Rate = $25 per machine hour
So, for every machine hour you clock while manufacturing your furniture during the year, you would apply $25 of your estimated overhead costs to that product.
Then, at the end of the year, you’d adjust for any overapplied or underapplied overhead based on the actual costs and machine hours for the year. This method helps provide more accurate product costing and financial reporting, but it does require a reasonable and consistent method of estimating costs and activity bases.
