It is a method manufacturers use to determine manufacturing overhead , ongoing expenses, for their work in progress inventory. It is calculated at the beginning of each reporting period. It is an estimated ratio of overhead costs calculated before a project or job begins.
Formula
To calculate the overhead rate:
Divide = Estimated Manufacturing overhead cost/ Estimated total units in allocation base
What is an allocation base? It is a cost based on activity that affects overhead costs, like labour hours, machine hours, cost of materials.
What is manufacturing cost?It includes utilities, supplies, employee salaries, rent and depreciation
Example for Better Understanding-
- 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 for the apportionment of their manufacturing cost. The manufacturing cost for the year has been calculated as $50,000. The labor hours estimated is 10,000 hours by the company.
- It will be calculated as:
- Predetermined Overhead Rate formula = 50000/10000 hours
- = $5/labor hr.
- The Blue Company uses a job order costing system and computes separate predetermined overhead rates for its cutting and finishing departments. The following estimates were made at the beginning of the year 2021:
Cutting department:
- Direct labor hours: 6,000 hours
- Machine hours: 48,000 hours
- Manufacturing overhead cost: $360,000
- Direct labor cost: $50,000
Finishing department:
- Direct labor hours: 30,000 hours
- Machine hours: 5,000 hours
- Manufacturing overhead cost: $486,000
- Direct labor cost: $270,000
The overhead rate of the cutting department is based on machine hours and that of the finishing department on direct labor cost.
Required: Work out predetermined overhead rate for each of the above two departments.
Solution
Cutting department:
Estimated manufacturing overhead cost/Estimated machine hours
= $360,000/48,000 hours
= $7.5 per machine hour
Finishing department:
Estimated manufacturing overhead cost/Estimated direct labor cost
= $486,000/$270,000
= $1.8 per dollar of direct labor
In the finishing department, the company would apply $1.80 of manufacturing overhead for each dollar of direct labor cost incurred by the department. To state it another way, we can say that the manufacturing overhead would be applied @ 180% (= 1.80 x 100) of direct labor cost.
Use of Calculating Predetermined Overhead Rate?
- It helps to identify indirect costs.
- It can help determine the cost of appropriate period (month, quarter, year)
- It helps businesses to balance expenses with production and sales.
- It helps to estimate future manufacturing costs so that companies can plan, budget and monitor costs.
- It can help estimate the costs so the company can determine an accurate price that still allows them to earn a profit.
- It provides a more consistent analysis even during periods of season variability
Concerns
- The rates aren’t realistic because they are based on accounting estimates.
- Actual overheads could turn out to be different than the estimate because the production hasn’t taken place and is based on forecast or through previous accounting records.
- Unexpected expenses can be a result of a big difference between actual and estimated overheads.
- Prices increase all the time and industry trends and consumer expectations are changing.
Conclusion
It helps the management to distribute the expenses to its cost centers. Predetermined overhead is determined at the beginning of the year. Large organization uses overhead recovery rates to allocate its expenses to the cost centers. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost. Small organizations with small budgets cannot afford to have multiple predetermined overhead allocation mechanisms since it requires experts to determine that the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too.same.
FAQS
- Who uses the predetermined overhead rate?
Small companies typically use activity based costing, hence it is used by large organizations.
- What are some common methods of factory overhead absorption?
Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods to factory overhead absorption rate.
- How is the predetermined overhead rate used?
It is used to price new products and to calculate variances in overhead costs.
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