How to Determine Predetermined Overhead Rate

A predetermined overhead rate is an estimated rate used to apply indirect manufacturing costs to products or services. This rate allows companies to assign overhead costs to production throughout an accounting period, even before actual overhead costs are fully known. Its purpose is to aid product costing, helping set prices, value inventory, and make informed production and profitability decisions. Using an estimated rate provides businesses with timely and consistent cost information for operational and financial reporting.

Identifying Estimated Overhead Costs

Overhead costs are indirect manufacturing expenses not directly traceable to specific products. These costs are necessary for production but do not directly become part of the finished good. Examples include indirect materials like lubricants, and indirect labor such as factory supervisors’ salaries. Other common overhead costs include factory utilities (electricity, natural gas) and factory rent.

Estimating these costs requires forecasting based on historical data and anticipated changes. Businesses review past utility bills, maintenance records, and depreciation schedules for factory equipment to establish a baseline. Adjustments are made for expected increases in utility rates, planned equipment upgrades that might alter depreciation, or changes in property taxes. This estimation ensures the predetermined rate reflects expected future conditions.

Forecasting also considers planned production volumes, influencing variable overhead costs like indirect materials or certain utilities. Management anticipates the level of activity within the factory to project associated expenses accurately. The goal is a comprehensive estimate of all manufacturing overhead for the period. This step is important for establishing the numerator of the predetermined overhead rate calculation.

Selecting an Activity Base

The activity base, the denominator in the predetermined overhead rate calculation, measures production activity that drives overhead costs. This base should have a strong cause-and-effect relationship with overhead costs. Common activity bases include direct labor hours, machine hours, direct labor cost, or units produced. Selecting an appropriate activity base is important for accurately allocating overhead.

For example, if a company’s overhead costs are primarily related to machinery operation, such as maintenance or electricity, then machine hours would be a suitable activity base. Conversely, if a significant portion of overhead is tied to supervision or training of production line workers, direct labor hours would be more appropriate. The chosen base should be easily measurable and trackable throughout the production process.

Estimating the total amount of the chosen activity base is the next step. This involves forecasting the total direct labor hours, machine hours, or units expected to be produced based on sales forecasts and production schedules. Historical activity levels provide a starting point, adjusted for any anticipated changes in production efficiency or volume. This estimated total activity base provides the necessary figure for the denominator, ensuring consistent application throughout the period.

Calculating and Applying the Rate

Once estimated total manufacturing overhead costs and the estimated total activity base are determined, the predetermined overhead rate can be calculated. The formula is: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead / Estimated Total Activity Base. This calculation yields a single rate used consistently throughout the accounting period. For instance, if a company estimates $600,000 in total manufacturing overhead and 120,000 estimated direct labor hours, the rate would be $5.00 per direct labor hour.

After calculating the rate, it is applied to individual jobs, products, or services as production occurs. This involves multiplying the predetermined overhead rate by the actual amount of the activity base consumed by a specific production unit. For example, if a production job uses 500 direct labor hours and the rate is $5.00 per direct labor hour, then $2,500 ($5.00 x 500) of manufacturing overhead is applied to that job. This applied overhead becomes part of the product’s total cost.

Applying this estimated rate allows for timely product costing, important for inventory valuation and determining cost of goods sold before actual overhead costs are finalized. This systematic application ensures products carry a share of indirect costs as they move through the production process. It provides a consistent method for attributing overhead, supporting decisions related to pricing and profitability analysis. This rate helps maintain a smooth flow of cost information throughout the fiscal year.

Addressing Differences Between Applied and Actual Overhead

At the end of an accounting period, total manufacturing overhead applied using the predetermined rate will differ from actual overhead costs incurred. This difference arises because the predetermined rate is based on estimates, and actual costs or activity levels may vary from these forecasts. When applied overhead is greater than actual overhead, the difference is known as overapplied overhead. Conversely, if applied overhead is less than actual overhead, it is called underapplied overhead.

Companies must account for these differences to ensure financial statements accurately reflect the true cost of production. For immaterial amounts, the most common accounting treatment is to close the entire balance of overapplied or underapplied overhead directly to Cost of Goods Sold. This adjustment effectively increases or decreases the Cost of Goods Sold for the period, correcting the initial overhead allocation. This method is simpler and often used when the discrepancy is small.

For material amounts, generally accepted accounting practices suggest prorating the overapplied or underapplied overhead among Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold. This proration allocates the difference proportionally to where the overhead resides within the company’s accounts. This approach ensures inventory balances and the cost of goods sold more accurately reflect the actual overhead costs incurred. The adjustment corrects the temporary discrepancy caused by using an estimated rate.