How to Calculate the Predetermined Overhead Rate

The predetermined overhead rate serves as a mechanism for allocating indirect manufacturing costs to products or services. It allows businesses to assign a portion of costs that cannot be directly traced to specific units, such as factory rent or utilities, to the items being produced. This rate helps in determining the full cost of production, which is important for various financial and operational decisions.

Understanding Predetermined Overhead Rate

The predetermined overhead rate is an estimated rate calculated before an accounting period begins. This estimation is important because actual overhead costs are often not known until the end of a period, making timely cost determination difficult. By using a predetermined rate, businesses can apply overhead costs to products or jobs throughout the period as production occurs.

This proactive approach provides more immediate cost information, which is useful for setting prices, valuing inventory, and making other operational decisions. For instance, knowing estimated product costs allows for competitive pricing strategies without waiting for all actual costs to be finalized. It also ensures that inventory values on financial statements include an appropriate share of indirect costs, which is a requirement under IRS regulations.

Identifying Overhead Costs and Activity Bases

Before calculating the predetermined overhead rate, businesses must identify and estimate their total overhead costs for the upcoming period. Overhead costs encompass all indirect manufacturing costs that are not direct materials or direct labor. These can include a wide range of expenses such as indirect materials (e.g., lubricants for machinery), indirect labor (e.g., factory supervisors’ salaries), factory rent, utilities, property taxes on the factory building, and depreciation on factory equipment.

After estimating total overhead costs, a business must select an appropriate “activity base,” also known as an allocation base or cost driver. Common activity bases include direct labor hours, machine hours, direct labor costs, or units produced.

The chosen activity base should have a logical cause-and-effect relationship with the overhead costs being allocated. For instance, if a company’s indirect costs like utilities and depreciation are heavily influenced by how long machines run, then machine hours would be a suitable choice. Finally, the business must estimate the total quantity of the chosen activity base for the upcoming period. For example, if direct labor hours are chosen, the total number of hours expected to be worked by direct laborers during the period must be estimated.

The Calculation Process

The predetermined overhead rate is calculated using a straightforward formula: Estimated Total Overhead Costs divided by Estimated Total Activity Base. The accuracy of the rate depends heavily on the reliability of the initial estimates for both overhead costs and the activity base.

To illustrate, consider a manufacturing company that has estimated its total overhead costs for the upcoming year to be $200,000. The company determines that direct labor hours are the most appropriate activity base, and it estimates that 40,000 direct labor hours will be worked during the year.

Applying the formula, the predetermined overhead rate is calculated as $200,000 (Estimated Total Overhead Costs) divided by 40,000 direct labor hours (Estimated Total Activity Base). This calculation yields a predetermined overhead rate of $5 per direct labor hour. This rate means that for every direct labor hour worked, $5 of overhead will be applied to the products being manufactured.

Using the Calculated Rate

Once the predetermined overhead rate has been calculated, it is used throughout the accounting period to apply overhead costs to individual products or jobs. The formula for applied overhead is the Predetermined Overhead Rate multiplied by the Actual Activity Base Incurred. For example, if the rate is $5 per direct labor hour and a job uses 100 direct labor hours, then $500 of overhead ($5 x 100) is applied to that job.

This applied overhead is then added to the direct material and direct labor costs to determine the total manufacturing cost of a product or job. This full cost information is important for internal decision-making and for external financial reporting. It helps in valuing inventory on the balance sheet and calculating the cost of goods sold on the income statement.