How to Calculate the Predetermined Overhead Rate

A predetermined overhead rate is a calculated allocation rate businesses use to apply estimated manufacturing overhead costs to products or jobs. This rate is established at the beginning of an accounting period, typically a fiscal year, before actual overhead costs are fully known. Its primary purpose is to enable timely product costing, crucial for setting prices, making production decisions, and preparing financial statements. Without a predetermined rate, companies would wait until the end of the period to gather all actual overhead costs, delaying financial reporting and decision-making. This proactive approach allows for consistent application of indirect costs, supporting immediate cost analysis and profitability assessments.

Understanding the Necessary Inputs

Calculating a predetermined overhead rate requires two main estimated components: estimated total manufacturing overhead costs and an estimated total activity base. Manufacturing overhead includes all indirect costs associated with the production process that cannot be directly traced to a specific product. These expenses are essential for factory operations but do not become a physical part of the finished good. Examples include indirect materials like cleaning supplies or lubricants, indirect labor such as factory supervisors’ salaries, factory utility costs, rent for the manufacturing facility, and depreciation on factory equipment.

The second input is the estimated total activity base, also known as an allocation base or cost driver. This measure of activity is expected to correlate with the incurrence of overhead costs. It represents a quantifiable metric that drives indirect resources. Like overhead costs, this measure is also an estimate for the upcoming period. Common examples of activity bases include direct labor hours, machine hours, direct labor cost, or the number of units produced.

Choosing an Appropriate Activity Base

Selecting the most appropriate activity base is an important decision, as it directly impacts how overhead costs are distributed. The choice should reflect a cause-and-effect relationship with the overhead costs incurred.

For instance, if a company’s overhead is primarily driven by human effort, direct labor hours might be suitable. This base is often appropriate for labor-intensive operations where indirect costs, such as supervision or factory support, vary with the amount of labor utilized. Conversely, in highly automated production environments, machine hours often serve as a more appropriate activity base.

This choice reflects that many overhead costs, like machine maintenance, power consumption, or equipment depreciation, are directly tied to the operational time of machinery. Other common bases include direct labor cost, useful when different labor rates exist, or direct materials cost, though less common as material cost does not always correlate with overhead. The number of units produced can also be used, particularly in simpler production processes where overhead costs increase proportionally with each unit manufactured. The chosen base must be measurable and logically align with how the business consumes its indirect resources.

Performing the Calculation

Once the estimated total manufacturing overhead costs and the estimated total activity base are determined, the predetermined overhead rate can be calculated using a straightforward formula: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Activity Base. This calculation yields a rate used to apply overhead to products or jobs throughout the accounting period.

For example, assume a manufacturing company estimates its total manufacturing overhead costs for the upcoming year will be $600,000. The company has determined that direct labor hours are the most appropriate activity base, estimating 150,000 direct labor hours for the same period. To perform the calculation, $600,000 in estimated overhead costs is divided by 150,000 estimated direct labor hours. This results in a predetermined overhead rate of $4.00 per direct labor hour. This means that for every direct labor hour worked on a product or job, $4.00 of overhead will be allocated.

Using the Predetermined Overhead Rate

After calculating the predetermined overhead rate, businesses use this rate to apply overhead costs to specific products or jobs as production occurs. This process is known as applying overhead. The amount of overhead applied to a particular job or unit is determined by multiplying the predetermined overhead rate by the actual amount of the activity base consumed. For instance, if a job required 50 direct labor hours and the predetermined overhead rate is $4.00 per direct labor hour, then $200 (50 hours $4.00/hour) of overhead would be applied to that specific job.

This applied overhead becomes part of the product’s total cost, joining direct materials and direct labor in the work-in-process inventory. Including overhead in product costs is important for valuing inventory on the balance sheet and calculating the cost of goods sold on the income statement, which aligns with generally accepted accounting principles (GAAP).