What Is POHR in Accounting? How to Calculate and Apply It

Overhead costs are indirect expenses businesses incur to operate, which cannot be directly traced to specific products or services. These costs are necessary for production but do not become a physical part of the product. To account for these indirect costs and assign them to produced items, businesses use the predetermined overhead rate (POHR). This rate helps estimate and apply indirect costs to goods or services throughout an accounting period, providing a complete picture of product cost.

Understanding Predetermined Overhead Rate (POHR)

The predetermined overhead rate (POHR) is an estimated allocation rate. It applies manufacturing overhead costs to products or jobs before actual costs are known. Calculated at the beginning of an accounting period, POHR enables timely product costing. Waiting for actual overhead figures until the end of a period would delay financial reporting and decision-making.

POHR helps businesses smooth out overhead cost fluctuations, like seasonal utility expenses. This consistency aids in pricing decisions and preparing competitive bids for new jobs or contracts. The rate also simplifies the overall cost accounting process, allowing for more efficient allocation of indirect expenses.

Manufacturing overhead costs include all indirect expenses related to production, excluding direct materials or direct labor. Examples are factory rent, production facility utilities, manufacturing equipment depreciation, and indirect labor like supervisor or maintenance staff salaries. These costs are essential for manufacturing operations but are not directly traceable to individual units.

Calculating Predetermined Overhead Rate

The predetermined overhead rate calculation uses estimates made at the start of an accounting period. The formula is: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of the Allocation Base. Both the numerator and the denominator are projections for the upcoming period.

The numerator, “Estimated Total Manufacturing Overhead Costs,” includes all indirect costs expected in production. This encompasses fixed overheads like factory rent and property taxes, and variable overheads such as indirect materials (e.g., lubricants, cleaning supplies) and indirect labor (e.g., quality control staff wages). Businesses gather these estimates using historical data, industry standards, and management judgment.

The denominator, “Estimated Total Amount of the Allocation Base,” measures activity that drives overhead costs. Common allocation bases include direct labor hours, machine hours, or direct labor costs. The selection of an appropriate allocation base is important; it should be a cost driver with a causal relationship to overhead costs. For example, automated production might use machine hours, while labor-intensive operations might choose direct labor hours.

A company estimates its total manufacturing overhead costs for the year to be $200,000 and production will require 10,000 direct labor hours. Using the formula, the predetermined overhead rate is $200,000 / 10,000 direct labor hours, resulting in $20 per direct labor hour. This means $20 of overhead is applied for every direct labor hour worked.

Applying Predetermined Overhead Rate

Once calculated, POHR applies overhead costs to specific jobs or products throughout the accounting period. This application occurs by multiplying the POHR by the actual amount of the allocation base incurred for a unit or job. The formula is: Applied Overhead = Predetermined Overhead Rate x Actual Amount of Allocation Base.

Continuing the previous example, if POHR is $20 per direct labor hour and a job uses 50 direct labor hours, the applied overhead is $20 x 50 = $1,000. This applied overhead becomes part of the product’s total cost.

Applied overhead, along with direct materials and direct labor costs, contributes to a good’s total production cost. This approach allows businesses to determine the full cost of products as they are manufactured, enabling timely decision-making regarding pricing and profitability.

POHR relies on estimated costs and activity levels, so the amount of overhead applied to products during a period will differ from the actual overhead costs incurred. This difference results in either underapplied overhead (actual overhead exceeds applied) or overapplied overhead (applied overhead exceeds actual). These differences are typically adjusted in accounting records at the end of the accounting period to reconcile estimated and actual figures.