How to Calculate Predetermined Overhead Rate: Formula & Uses

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The predetermined overhead rate formula can be used to balance expenses with production costs and sales. For businesses in manufacturing, establishing and monitoring an overhead rate can help keep expenses proportional to production volumes and sales. It can help manufacturers know when to review their spending more closely, in order to protect their business’s profit margins.

Assess the level of activity

• Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units.
• However, estimating does not involve predicting or forecasting instead it only involves quantifying for an interval of time.
• Using activity based costing, it is possible to understand the value of an activity and cost it accordingly instead of using time as a basis for allocating overheads.
• Hence, the overhead incurred in the actual production process will differ from this estimate.
• This rate is useful from the point of view of cost control as it enables management to plan ahead and budget for the future.

According to a survey 34% of the manufacturing businesses use a single plant wide overhead rate, 44% use multiple overhead rates and rest of the companies use activity based costing (ABC) system. Notice that the formula of predetermined overhead rate is entirely based on estimates. The overhead applied to products or job orders would, therefore, be different from the actual overhead incurred by jobs or products. The comparison of applied QuickBooks and actual overhead gives us the amount of over or under-applied overhead during the period which is eliminated through recording appropriate journal entries at the end of the period.

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The actual total manufacturing overhead incurred for the year was $247,800 and actual direct labor hours worked during the year were 42,000. The actual overhead rate enables the recovery of the actual amount of overhead. However, its main drawback is that it is historical in nature; it can only be ascertained after the overhead costs have been incurred and measured. As such, the actual overhead rate is useless from the point of view of cost control. These overhead costs involve the manufacturing of a product such as facility utilities, facility maintenance, equipment, supplies, and labor costs. Whereas, the activity base used for the predetermined overhead rate calculation is usually machine hours, direct labor hours, or direct labor costs.

Step 2 of 3

Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units. Any difference between applied overhead and the amount of overhead actually incurred is called over- or under-applied overhead. A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours.

Monitoring relative expenses

In a company, the management wants to calculate the predetermined overhead to set aside some amount for the allocation of a cost unit. Therefore, they use labor hours https://www.bookstime.com/ for the apportionment of their manufacturing cost. The formula for the predetermined overhead rate is purely based on estimates.

What are some concerns surrounding the use of a predetermined overhead rate?

• For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
• The price a business charges its customers is usually negotiated or decided based on the cost of manufacturing.
• In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation.
• This comparison can be used to monitor or predict expenses for the next project (or fiscal year).
• Businesses normally face fluctuation in product demand due to seasonal variations.
• The elimination of difference between applied overhead and actual overhead is known as “disposition of over or under-applied overhead”.

One of the advantages of predetermined overhead rate is that businesses can use it to help with closing their books more quickly. This is because using this rate allows them to avoid compiling actual overhead costs as part of predetermined overhead rate their closing process. Nonetheless, it is still essential for businesses to reconcile the difference between the actual overhead and the estimated overhead at the end of their fiscal year. Hence, it is essential to use rates that determine how much of the overhead costs are applied to each unit of production output. This is why a predetermined overhead rate is computed to allocate the overhead costs to the production output in order to determine a cost for a product.

Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials cost incurred by the process. Albert Shoes Company calculates its predetermined overhead rate on the basis of annual direct labor hours. At the beginning of year 2021, the company estimated that its total manufacturing overhead cost would be $268,000 and the total direct labor cost would be 40,000 hours.