What Is a Predetermined Overhead Rate?
Learn how businesses utilize an estimated rate to consistently allocate indirect costs to products, enabling accurate costing and financial insights.
A predetermined overhead rate is a valuable tool in cost accounting, designed to streamline the process of assigning indirect manufacturing costs to products or services. This estimated rate is established at the beginning of an accounting period and used consistently throughout. Its fundamental purpose is to enable businesses to determine the estimated full cost of a product or service in a timely manner, without waiting for actual indirect costs to be finalized. This proactive approach aids in various management decisions, such as pricing, inventory valuation, and cost control.
Understanding Overhead Costs
Overhead costs encompass all indirect expenses necessary for a business’s operations that cannot be directly traced to a specific product or service. These costs support the production process but do not become a physical part of the finished good. Common examples in manufacturing include factory rent, utilities, and depreciation on manufacturing equipment.
Other overhead examples include indirect labor, such as factory supervisors or maintenance staff, and indirect materials like cleaning supplies. These expenses are grouped as “overhead” because directly assigning them to individual units would be impractical. Their benefit extends to the overall production process rather than to a single product unit.
Calculating the Predetermined Rate
Calculating the predetermined overhead rate involves two primary components: estimated total overhead costs and an estimated activity base. The process begins by forecasting all indirect manufacturing costs anticipated for a future period. These estimated costs might include factory utilities, indirect labor and materials, and depreciation on factory assets.
Next, a company selects an estimated activity base, also known as an allocation base. This base should be a measure of activity that correlates with the incurrence of overhead costs. Common examples include direct labor hours, machine hours, or direct labor dollars.
The formula for the predetermined overhead rate is: Predetermined Overhead Rate = Estimated Total Overhead Costs / Estimated Total Activity Base. For instance, if a company estimates total manufacturing overhead for the year to be $500,000 and anticipates 10,000 direct labor hours, the predetermined overhead rate would be $50 per direct labor hour ($500,000 / 10,000 hours). This rate is then used throughout the accounting period to apply overhead.
Applying Overhead to Products
Once the predetermined overhead rate is calculated, businesses use it to apply overhead to individual jobs, products, or services throughout the accounting period. This application occurs as production activities take place, rather than waiting until actual overhead costs are known at the end of the period. For example, if the rate is $50 per direct labor hour, and a specific job requires 100 direct labor hours, $5,000 ($50 x 100 hours) of overhead would be assigned to that job.
This assigned amount is referred to as “applied overhead.” Applying overhead based on a predetermined rate allows companies to determine the estimated full cost of products as they are being manufactured or completed. This enables timely decision-making regarding product pricing and inventory valuation.
Actual Versus Applied Overhead
Since the predetermined overhead rate relies on estimated figures, the total amount of overhead applied to production during an accounting period will rarely exactly match the actual overhead costs incurred. This difference leads to either “underapplied overhead” or “overapplied overhead.” Underapplied overhead occurs when actual overhead costs are greater than the overhead applied to production. Conversely, overapplied overhead arises when actual overhead costs are less than the amount applied. These variances are a normal outcome of using estimated rates.
At the end of the accounting period, companies reconcile this difference to ensure financial statements accurately reflect actual costs. The most common approach involves adjusting the Cost of Goods Sold account for the amount of underapplied or overapplied overhead. This adjustment ensures the true cost of production is reflected in financial records.