How to Compute Predetermined Overhead Rate

A predetermined overhead rate assigns indirect manufacturing costs to products or services in cost accounting. Businesses calculate this rate at the start of an accounting period by estimating future overhead expenses. This allows companies to allocate costs to products as they are manufactured, rather than waiting until actual overhead costs are known. Its purpose is to enable timely decision-making regarding pricing, budgeting, and cost control. Using a predetermined rate helps smooth out cost fluctuations, providing a more consistent unit cost for products.

Understanding and Estimating Overhead Costs

Overhead costs are indirect expenses incurred during manufacturing or service delivery, untraceable to a specific product or service. These are distinct from direct costs, such as raw materials and direct labor, which are directly involved in production. Examples of common manufacturing overhead costs include factory rent, utilities for the production facility, depreciation on factory equipment, indirect labor (like supervisors’ salaries or maintenance staff wages), and indirect materials (such as cleaning supplies or lubricants for machinery).

Accurately estimating these total overhead costs for an upcoming accounting period is a preparatory step. Businesses often rely on historical data from previous periods, reviewing past budgets, and making future projections based on anticipated operational changes or economic conditions. For instance, a company might analyze utility bills from the past year, adjusting for expected changes in energy prices or production volume. The precision of this estimation significantly impacts the effectiveness of subsequent cost allocation and overall financial management.

Choosing an Allocation Base

An allocation base, also known as a cost driver, is a measurable factor used to distribute overhead costs to products or services. It serves as the denominator in the predetermined overhead rate formula and should ideally have a strong cause-and-effect relationship with the incurrence of overhead. For example, if machine usage directly influences electricity costs and maintenance expenses, then machine hours would be an appropriate allocation base.

Common examples of allocation bases include direct labor hours, machine hours, direct labor cost, or even units produced. The selection depends on the nature of the business and which activity best drives the overhead costs. For a labor-intensive operation, direct labor hours might be most suitable, while a highly automated facility might find machine hours to be a more accurate measure. Estimating the total amount of the chosen allocation base for the upcoming period is also necessary, often based on production forecasts or historical activity levels.

Performing the Calculation

Once estimated total overhead costs and the estimated total activity of the chosen allocation base are determined, calculating the predetermined overhead rate is straightforward. The formula for this calculation is: Estimated Total Overhead Costs / Estimated Total Activity Base. This calculation yields a rate, often expressed as a dollar amount per unit of the allocation base, such as “$X per direct labor hour” or “$Y per machine hour.”

For example, imagine a manufacturing company estimates its total manufacturing overhead for the upcoming year to be $500,000. If the company chooses direct labor hours as its allocation base and estimates a total of 20,000 direct labor hours for the year, the predetermined overhead rate would be $25 per direct labor hour ($500,000 / 20,000 hours). This rate is established at the beginning of the period and typically remains constant throughout the year, providing a consistent cost application.

Using the Predetermined Overhead Rate

After calculating the predetermined overhead rate, businesses use it to apply overhead costs to products, jobs, or services throughout the accounting period. This application occurs by multiplying the predetermined overhead rate by the actual amount of the allocation base consumed by each product or job. The formula for applied overhead is: Predetermined Overhead Rate x Actual Activity Base Used. This process allows for the timely determination of a product’s total cost, including its share of indirect expenses, without waiting for actual overhead costs to be finalized.

For instance, if the predetermined overhead rate is $25 per direct labor hour, and a specific product requires 5 direct labor hours to produce, then $125 ($25/hour x 5 hours) of overhead would be applied to that product. The applied overhead is then added to the product’s direct material and direct labor costs to determine its total manufacturing cost. It is important to note that the total overhead applied using this rate may not perfectly match the actual overhead costs incurred by the end of the period, leading to either over-applied or under-applied overhead.