How to Find the Predetermined Overhead Rate

A predetermined overhead rate serves as an estimated cost allocation tool used in manufacturing. This rate applies indirect production costs, known as manufacturing overhead, to goods or services during the accounting period. Businesses use it to assign a portion of these costs to each unit produced, facilitating more accurate product costing and informed pricing decisions. Utilizing an estimated rate throughout the year also helps in managing operational efficiency by providing consistent cost data. This rate is particularly useful for companies that produce a variety of products, allowing for a standardized approach to cost allocation and aiding financial reporting and inventory valuation.

Understanding Overhead Costs and Activity Bases

Manufacturing overhead costs are indirect expenses incurred in the production process that cannot be directly traced to a specific product unit. These costs are necessary for manufacturing but do not become a physical part of the finished good. Examples include the rent paid for the factory building, the cost of utilities like electricity and gas used in the plant, and depreciation on manufacturing equipment.

Other examples of manufacturing overhead include indirect labor, such as the wages of factory supervisors, maintenance staff, or quality control inspectors. Indirect materials, like lubricants for machinery, cleaning supplies for the factory floor, or small tools that are not part of the final product, also fall into this category. These costs are distinct from direct costs, which are easily traceable to a specific product, such as raw materials or direct labor wages.

Estimating total manufacturing overhead for an upcoming period involves forecasting all indirect production expenses. This requires reviewing historical cost data, considering expected changes in prices for utilities or rent, and anticipating new equipment purchases or staffing adjustments. For instance, a company might look at its past 12 months of factory utility bills and adjust for an anticipated 3% increase in energy rates. Indirect labor costs would also be estimated based on projected staffing levels and average wage rates.

An activity base, also known as an allocation base, is a measure used to distribute estimated overhead costs to products or jobs. It is ideally a cost driver, meaning it is the primary factor that causes the overhead costs to be incurred. Common activity bases include direct labor hours, machine hours, direct labor costs, or the number of units produced. The selection of an activity base is important because it should logically relate to how overhead costs are consumed.

For example, if overhead costs are primarily driven by worker time, direct labor hours would be a suitable activity base. If machinery is the main source of overhead, such as high electricity consumption or maintenance expenses, then machine hours would be a more appropriate base. Businesses must estimate the total amount of the chosen activity base for the upcoming period. This involves forecasting production volume, considering labor or machinery efficiency, and reviewing past operational data. For instance, if a company plans to produce 10,000 units and each unit requires 0.5 direct labor hours, the estimated total direct labor hours would be 5,000.

Calculating the Predetermined Overhead Rate

Once the total estimated manufacturing overhead and the total estimated activity base are determined, the predetermined overhead rate can be calculated using a straightforward formula: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead / Estimated Total Activity Base. This yields a single rate, typically expressed as a dollar amount per unit of the activity base (e.g., dollars per direct labor hour or machine hour), used to apply overhead costs throughout the accounting period.

To illustrate, a manufacturing company projects its total manufacturing overhead costs for the upcoming year to be $500,000. This estimate includes items like factory rent, utilities, indirect labor, and depreciation. The company estimates its machines will operate for a total of 25,000 machine hours, as machine usage primarily drives its overhead costs.

Using these figures, the predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead by the estimated total machine hours. So, $500,000 (Estimated Total Manufacturing Overhead) divided by 25,000 machine hours (Estimated Total Activity Base) equals $20 per machine hour. This rate will be used to allocate overhead costs to its products for the entire year.

This rate remains constant throughout the period, even if actual overhead costs or activity levels differ from estimates. The purpose of using a predetermined rate is to provide a stable cost for products, allowing for consistent pricing and inventory valuation. It avoids the volatility that would result from using actual overhead costs, which can fluctuate significantly. The calculation is typically performed at the beginning of an accounting period.

The calculated rate is then applied to each product or job based on its actual consumption of the activity base. For example, if a specific job required 100 machine hours, it would be allocated $2,000 of overhead cost ($20 per machine hour x 100 machine hours). This systematic application helps ensure that all manufacturing costs are assigned to the products that incurred them.

Applying and Adjusting Overhead

After the predetermined overhead rate is calculated, it is used to apply manufacturing overhead to individual products or jobs throughout the period. Applied overhead for a specific job or product is determined by multiplying the predetermined overhead rate by the actual amount of the activity base consumed. For instance, if the rate is $20 per machine hour and a production run uses 50 actual machine hours, then $1,000 ($20 x 50) of overhead is applied. This allows for timely costing of jobs as they are completed.

At the end of an accounting period, businesses compare total applied overhead with total actual manufacturing overhead costs. If actual overhead is less than applied overhead, the difference is known as overapplied overhead. Conversely, if actual overhead is greater than applied overhead, it results in underapplied overhead.

These discrepancies occur because initial estimates for total manufacturing overhead or the total activity base were not perfectly accurate. For example, utility costs might have been lower than anticipated, or production volumes higher. Adjustments are generally made to account for these differences. The most common method for adjusting over or underapplied overhead is to close the balance to the Cost of Goods Sold account.

If overhead was overapplied, the Cost of Goods Sold account is typically debited, reducing its balance and increasing net income. If overhead was underapplied, the Cost of Goods Sold account is credited, increasing its balance and decreasing net income. For material amounts, the adjustment might be allocated proportionally to Cost of Goods Sold, Work-in-Process Inventory, and Finished Goods Inventory.