How to Calculate the Predetermined Overhead Rate

The predetermined overhead rate is an estimated allocation rate used in manufacturing to assign indirect production costs, known as overhead, to products or services. This rate provides a consistent method for allocating costs, particularly for product costing, inventory valuation, and informed pricing decisions, even before actual overhead expenses are finalized. It allows businesses to understand product costs in real-time throughout an accounting period, enabling more timely financial reporting and operational insights.

Gathering Necessary Information

Establishing a predetermined overhead rate begins with meticulously gathering and estimating two crucial components: total overhead costs and a suitable activity base for an upcoming accounting period. Overhead costs encompass all indirect manufacturing expenses that cannot be directly traced to a specific product or service. These typically include items such as factory rent, utilities consumed by the production facility, salaries for indirect labor like production supervisors, depreciation of manufacturing equipment, factory insurance premiums, and property taxes levied on the manufacturing plant. The accuracy of the predetermined overhead rate heavily relies on the precision of these future cost estimations.

Estimating these overhead costs requires reviewing historical spending patterns, adjusted for any anticipated changes in operational scale, material costs, or labor rates. Businesses often consult operational budgets to project these expenses, factoring in expected increases or decreases in production volume. The goal is to forecast the total amount of indirect costs the factory expects to incur over the defined period, such as a fiscal year.

The second component is the estimated total activity base, also known as an allocation base or cost driver. This is a measure of activity that is believed to cause or correlate with the incurrence of overhead costs. Common examples include direct labor hours, machine hours, the total cost of direct labor, the number of units expected to be produced, or the total cost of direct materials. The selection of an appropriate activity base is critical, as it should ideally have a strong causal relationship with the overhead costs being allocated.

For instance, if a company’s overhead costs are primarily driven by the amount of time machinery operates, then machine hours would be a more suitable activity base than direct labor hours. Estimating the total quantity of the chosen activity base for the upcoming period involves projecting the total expected usage or output. If direct labor hours are selected, the company would estimate the total direct labor hours anticipated to be worked in the factory during the period. This careful estimation of both overhead costs and the activity base provides the foundational inputs for the subsequent calculation.

Calculating the Predetermined Overhead Rate

Once the necessary financial and operational estimates have been carefully compiled, the predetermined overhead rate can be calculated using a straightforward formula. The formula is simply the estimated total overhead costs divided by the estimated total activity base. This calculation yields a single rate that will be used to apply overhead to production throughout the period.

For example, consider a manufacturing company that estimates its total overhead costs for the upcoming year to be $500,000. If the company determines that direct labor hours are the most appropriate activity base and estimates a total of 25,000 direct labor hours for the same period, the calculation is then performed. Dividing the estimated $500,000 in overhead by the 25,000 estimated direct labor hours results in a predetermined overhead rate of $20 per direct labor hour. This rate signifies that for every direct labor hour expected to be worked, $20 of overhead will be allocated to the products.

The calculated rate serves as a standardized measure for allocating indirect costs. It translates the total estimated overhead into a per-unit or per-activity measure, making it easier to assign these costs to individual jobs or products. This allows businesses to incorporate a portion of their indirect manufacturing costs into the cost of goods produced even before the period’s actual overhead expenses are known.

Applying the Predetermined Overhead Rate

After the predetermined overhead rate has been calculated, it is then used to apply overhead costs to individual products, jobs, or services as they are manufactured throughout the accounting period. The amount of overhead applied to a specific item or job is determined by multiplying the predetermined overhead rate by the actual amount of the activity base consumed by that particular item or job. This means that if the rate is based on machine hours, the actual machine hours used for a job would be multiplied by the predetermined rate.

For instance, if the predetermined overhead rate is $20 per direct labor hour, and a specific production job required 100 actual direct labor hours to complete, then $2,000 ($20/hour x 100 hours) in overhead would be applied to that job. This applied overhead is then added to the direct materials and direct labor costs incurred for the job to determine its total manufacturing cost. The purpose of applying overhead in this manner is to ascertain the full cost of a product or job, which is crucial for accurate inventory valuation on the balance sheet, calculating the cost of goods sold on the income statement, and making informed pricing decisions.

This process provides a consistent and timely method for costing products, allowing management to make decisions without waiting for actual overhead costs to be finalized at the end of the accounting period. While actual overhead costs will inevitably differ from the overhead applied using the predetermined rate, leading to either underapplied or overapplied overhead, the initial application provides an immediate and reasonable estimate of full production costs. The difference between applied and actual overhead is typically addressed at the end of the period through accounting adjustments.