How to Calculate Predetermined Manufacturing Overhead Rate

The predetermined manufacturing overhead rate is a foundational concept in cost accounting, allowing businesses to estimate indirect production costs for a future period. This estimated rate helps in assigning overhead costs to products or jobs in a consistent and timely manner. Its primary purpose is to facilitate product costing, aid in bidding on new projects, and ensure more consistent financial reporting, especially when actual overhead costs are not yet known. Using a predetermined rate avoids delays in determining product costs, which would occur if companies waited for actual overhead figures to become available at the end of an accounting period.

Identifying Estimated Total Manufacturing Overhead Costs

Manufacturing overhead encompasses all indirect costs incurred during the production process that cannot be directly traced to specific products. These costs are necessary for factory operations but do not include direct materials or direct labor. Examples include indirect materials (like lubricants or cleaning supplies) and indirect labor (wages for factory supervisors, maintenance staff, and quality control personnel).

Other components of estimated total manufacturing overhead costs include factory utilities (electricity, water, natural gas), factory rent or depreciation on the factory building, equipment depreciation, maintenance, and repairs for production machinery. Property taxes and insurance premiums related to the manufacturing facility also contribute to the total estimated overhead.

Estimating these costs for a future period, typically a year, is a key step in calculating the predetermined overhead rate. Companies often rely on historical data analysis to identify past trends in overhead expenses. Budgeting processes also play a role, where anticipated changes in production volume, utility rates, or labor costs are factored into the estimates.

Managerial judgment is another element in the estimation process, incorporating insights from production managers and other relevant departments. For instance, if a company plans to expand its production capacity or invest in new machinery, these strategic decisions will influence future overhead costs.

Selecting an Estimated Activity Base

An activity base, also known as an allocation base or cost driver, is the measure used to distribute manufacturing overhead costs to products or services. This base should ideally have a cause-and-effect relationship with the incurrence of overhead costs, meaning that as the activity base increases, overhead costs should also tend to increase. Accurate cost allocation relies on choosing an appropriate activity base.

Common activity bases used in manufacturing include direct labor hours, machine hours, direct labor cost, and units produced. For example, in a labor-intensive production environment, direct labor hours might be a suitable activity base because many overhead costs, such as supervision and factory support, are often driven by the amount of labor utilized.

Conversely, in highly automated facilities, machine hours may be a more appropriate base as machine usage directly influences costs like power consumption, maintenance, and depreciation. The rationale behind selecting a specific activity base depends on the nature of the production process and the primary drivers of overhead within that process.

Considerations include the availability of reliable data for tracking the chosen base and the cost-benefit of collecting such data. While a more precise allocation might involve multiple activity bases, many companies opt for a single, plant-wide base for simplicity, especially smaller organizations.

The estimated total amount of the chosen activity base for the upcoming period must be determined concurrently with the estimated overhead costs. For instance, if direct labor hours are selected, the company must forecast the total direct labor hours expected to be worked during the year. This estimated activity base forms the denominator in the predetermined overhead rate calculation.

Performing the Calculation

Once the estimated total manufacturing overhead costs and the estimated total activity base have been determined, the predetermined manufacturing overhead rate can be calculated. This calculation is a straightforward division, applying the formula: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Activity Base. This rate represents the amount of overhead cost applied for each unit of the chosen activity base.

For example, consider a company that estimates its total manufacturing overhead costs for the upcoming year to be $500,000. If the company has selected machine hours as its activity base and estimates a total of 25,000 machine hours for the year, the calculation would proceed as follows: $500,000 (Estimated Total Manufacturing Overhead Costs) / 25,000 (Estimated Total Machine Hours). This yields a predetermined overhead rate of $20 per machine hour.

In another scenario, if the estimated total manufacturing overhead costs remain $500,000, but the company uses direct labor hours as the activity base, with an estimated 10,000 direct labor hours, the calculation changes. The rate would be $500,000 / 10,000 direct labor hours, resulting in a rate of $50 per direct labor hour. The resulting rate indicates how much overhead cost will be assigned for every hour a machine operates or every hour of direct labor performed. This calculated rate allows for the consistent application of overhead throughout the period. The formula relies entirely on estimates made at the beginning of an accounting period, before actual costs are known.

Applying the Calculated Rate

After the predetermined manufacturing overhead rate is calculated, it is then used to apply overhead costs to individual products, jobs, or services throughout the accounting period. This application occurs by multiplying the predetermined rate by the actual amount of the activity base consumed by each specific job or product. For instance, if the predetermined rate is $20 per machine hour, and a particular job uses 15 machine hours, $300 ($20 x 15 hours) of manufacturing overhead would be applied to that job.

Companies utilize this applied overhead for several practical reasons. It allows for timely product costing, enabling businesses to determine the total cost of a product as soon as it is completed. This immediate costing aids inventory valuation on the balance sheet, as generally accepted accounting principles (GAAP) require manufacturing overhead to be included in the cost of inventory.

The use of a predetermined rate also aids in bidding on new contracts or setting sales prices, as it provides a consistent and predictable cost component for planning purposes. This consistency helps in managing seasonal fluctuations in actual overhead costs or production volumes, providing a smoother cost per unit.

The applied overhead, based on estimated figures, will likely differ from the actual overhead costs incurred during the period. This difference results in either over-applied overhead, where more overhead was applied than actually incurred, or under-applied overhead, where less was applied. These variances are typically addressed through adjusting entries at the end of the accounting period, often by adjusting the Cost of Goods Sold account.