What Is the Predetermined Overhead Rate?

Overhead costs are ongoing business expenses not directly tied to creating a product or service, such as factory rent or utility bills. These indirect costs make determining the true cost of goods produced challenging. The predetermined overhead rate provides a systematic approach to apply indirect costs to products or services throughout an accounting period, aiding financial reporting and decision-making.

Understanding the Predetermined Overhead Rate

A predetermined overhead rate is an estimated rate businesses use to apply manufacturing overhead costs to products or services, established before actual costs are known. Its purpose is to enable timely product costing, allowing companies to determine approximate total costs as production occurs, rather than waiting until the end of the accounting period.

This estimated rate helps in valuing inventory and making prompt pricing decisions. Without it, companies would face delays in understanding product costs, hindering efficient operations. The predetermined overhead rate simplifies the allocation process for indirect costs, such as factory maintenance or depreciation on factory equipment.

Key Components for Calculation

Calculating the predetermined overhead rate requires two main components: estimated total manufacturing overhead costs and the estimated amount of an activity base. Estimated total manufacturing overhead costs include all indirect expenses related to the production process, such as indirect labor (like factory supervisors’ salaries), indirect materials (such as lubricants or cleaning supplies), factory rent, production facility utilities, and depreciation on factory equipment.

The activity base, also known as a cost driver or allocation base, is a measure of activity that causes overhead costs. Common examples include direct labor hours, machine hours, direct labor costs, or the number of units produced. For instance, if overhead costs are primarily influenced by machine operation time, then machine hours would be a suitable activity base.

Steps to Calculate the Rate

The predetermined overhead rate is calculated using the formula: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of the Activity Base. This calculation is typically performed at the beginning of an accounting period, often annually, to ensure consistency throughout the year.

To illustrate, a company first estimates its total manufacturing overhead costs for the upcoming period, perhaps $500,000 for the year. Next, it estimates the total amount of its chosen activity base for that same period. If the company uses machine hours as its activity base and estimates 10,000 machine hours for the year, the calculation would then be $500,000 divided by 10,000 machine hours. This results in a predetermined overhead rate of $50 per machine hour. This rate indicates that for every machine hour used in production, $50 of overhead cost will be applied to the products.

Applying the Rate in Business Operations

The predetermined overhead rate is used to apply overhead to individual products or jobs throughout the accounting period. Applied overhead is determined by multiplying the rate by the actual activity base used by a specific job or product. For example, if a product required 5 machine hours and the rate is $50 per machine hour, then $250 of overhead would be applied. This allows for the timely determination of a product’s total cost, which includes direct materials, direct labor, and the applied overhead.

The consistent application of overhead is valuable for inventory valuation, as U.S. Generally Accepted Accounting Principles (U.S. GAAP) require all manufacturing costs—direct materials, direct labor, and overhead—to be assigned to products for inventory costing. This ensures work-in-process and finished goods inventory are reported at full absorption cost on financial statements. A consistent cost per unit, including applied overhead, also assists companies in setting competitive and profitable selling prices. This rate also provides a benchmark for budgeting and cost control, helping management evaluate performance by comparing applied overhead to actual overhead costs.