How Is Predetermined Overhead Rate Calculated

Let's unravel the mystery of the predetermined overhead rate, a crucial concept for understanding cost accounting and effective business management.

Understanding Predetermined Overhead Rate

The predetermined overhead rate is an estimated overhead rate used to apply overhead costs to products or services during a specific period. It's calculated before the actual costs are known. Manufacturing overhead includes all the indirect costs incurred during the production process that are not direct materials or direct labor. Think of factory rent, utilities, depreciation on equipment, and indirect labor costs. Companies allocate these overhead costs to individual products or jobs to determine the total cost of production and make informed pricing decisions.

Why can't we just wait for the actual costs? Good question. The beauty of the predetermined overhead rate lies in its ability to provide timely cost information. Actual overhead costs are often not known until the end of the accounting period, and waiting until then to allocate these costs would delay pricing decisions and financial reporting. The predetermined overhead rate allows businesses to apply overhead costs consistently throughout the period, giving them a more accurate picture of product costs on an ongoing basis.

The Formula: A Simple Equation

The predetermined overhead rate is calculated using a straightforward formula:

Predetermined Overhead Rate = Estimated Total Overhead Costs / Estimated Total Allocation Base

Let's break down each component:

• Estimated Total Overhead Costs: This is the company's best guess of all indirect manufacturing costs for the upcoming period. This estimate is based on historical data, anticipated production levels, and any expected changes in overhead costs.
• Estimated Total Allocation Base: This is a measure of activity that is believed to drive overhead costs. Common allocation bases include:
  • Direct Labor Hours: If overhead costs are closely related to the amount of labor used in production.
  • Direct Labor Cost: If overhead costs are tied to the cost of labor.
  • Machine Hours: If production is heavily automated and overhead costs are driven by machine usage.
  • Units Produced: If overhead costs are relatively consistent per unit.

The selection of the allocation base is critical. It should have a strong correlation with the overhead costs being allocated. Choosing the wrong allocation base can lead to inaccurate product costs and flawed decision-making.

Step-by-Step Calculation: Bringing It to Life

Let's walk through a step-by-step example to illustrate how the predetermined overhead rate is calculated:

Scenario: ABC Manufacturing estimates its total overhead costs for the upcoming year to be $500,000. It plans to use direct labor hours as the allocation base and estimates total direct labor hours to be 25,000.

Step 1: Estimate Total Overhead Costs:

ABC Manufacturing has estimated its total overhead costs at $500,000. This includes all indirect manufacturing costs, such as factory rent, utilities, depreciation, and indirect labor.

Step 2: Estimate Total Allocation Base:

The company plans to use direct labor hours as the allocation base and has estimated total direct labor hours to be 25,000.

Step 3: Calculate the Predetermined Overhead Rate:

Using the formula:

Predetermined Overhead Rate = Estimated Total Overhead Costs / Estimated Total Allocation Base

Predetermined Overhead Rate = $500,000 / 25,000 Direct Labor Hours

Predetermined Overhead Rate = $20 per Direct Labor Hour

Interpretation: This means that for every direct labor hour worked, ABC Manufacturing will allocate $20 of overhead costs to the product or job.

Applying the Predetermined Overhead Rate

Once the predetermined overhead rate is calculated, it's used to apply overhead costs to individual products or jobs throughout the period.

Example (Continuing from the previous scenario):

Assume a specific job (Job #123) requires 100 direct labor hours. To apply overhead costs to this job, ABC Manufacturing would use the predetermined overhead rate:

Overhead Applied to Job #123 = Predetermined Overhead Rate x Actual Direct Labor Hours for Job #123

Overhead Applied to Job #123 = $20/Direct Labor Hour x 100 Direct Labor Hours

Overhead Applied to Job #123 = $2,000

Therefore, $2,000 of overhead costs would be applied to Job #123. This cost is then added to the direct materials and direct labor costs to determine the total cost of Job #123.

The Importance of Choosing the Right Allocation Base

The choice of the allocation base is a critical decision that can significantly impact the accuracy of product costs. The allocation base should have a strong causal relationship with the overhead costs being allocated. This means that changes in the allocation base should directly drive changes in the overhead costs.

Here's a closer look at common allocation bases and when they are most appropriate:

• Direct Labor Hours:
  • Suitable when: Overhead costs are primarily driven by labor-related activities, such as supervision, employee benefits, or quality control.
  • Example: A manufacturing company where a significant portion of overhead costs are related to the wages and benefits of supervisors who oversee direct labor employees.
• Direct Labor Cost:
  • Suitable when: Overhead costs are closely tied to the cost of labor, such as payroll taxes or workers' compensation insurance.
  • Example: A construction company where overhead costs include a large amount of payroll taxes and insurance directly related to the direct labor workforce.
• Machine Hours:
  • Suitable when: Production is highly automated and overhead costs are primarily driven by machine usage, such as depreciation, maintenance, and electricity.
  • Example: A manufacturing plant that uses a lot of automated machinery and where machine hours are the primary driver of overhead costs.
• Units Produced:
  • Suitable when: Overhead costs are relatively consistent per unit and there is little variation in the production process.
  • Example: A company that produces a single, standardized product in large quantities.

What happens if you choose the wrong allocation base?

Using an inappropriate allocation base can lead to cost distortion, which means that some products are overcosted while others are undercosted. This can result in poor pricing decisions, inaccurate profitability analysis, and ultimately, reduced profitability.

Example of Cost Distortion:

Imagine a company that produces two products: Product A and Product B. Product A is labor-intensive, while Product B is machine-intensive. If the company uses direct labor hours as the allocation base, Product A will be allocated a larger share of overhead costs, even if the actual overhead costs are driven more by machine usage. This will result in Product A being overcosted and Product B being undercosted.

Dealing with Overapplied or Underapplied Overhead

At the end of the accounting period, the actual overhead costs are compared to the overhead costs that were applied using the predetermined overhead rate. This comparison will reveal either overapplied overhead or underapplied overhead.

• Overapplied Overhead: This occurs when the amount of overhead applied to products or jobs exceeds the actual overhead costs incurred.
• Underapplied Overhead: This occurs when the amount of overhead applied to products or jobs is less than the actual overhead costs incurred.

Why does over/underapplication happen? The predetermined overhead rate is based on estimates, and actual costs and activity levels rarely match the estimates perfectly. Fluctuations in production volume, unexpected changes in overhead costs, or inaccurate initial estimates can all contribute to overapplied or underapplied overhead.

What to do with over/underapplied overhead? There are two common methods for dealing with overapplied or underapplied overhead:

1. Write-Off to Cost of Goods Sold (COGS): This is the simpler method and is typically used when the amount of overapplied or underapplied overhead is immaterial (small) relative to the total cost of goods sold. The overapplied overhead is credited to COGS (reducing COGS), while the underapplied overhead is debited to COGS (increasing COGS).
2. Allocation: This method is used when the amount of overapplied or underapplied overhead is material. The overapplied or underapplied overhead is allocated among work-in-process inventory, finished goods inventory, and cost of goods sold, based on the proportion of overhead included in each of these accounts.

Example of Write-Off to COGS:

Assume a company has underapplied overhead of $10,000 at the end of the year. If the company uses the write-off to COGS method, the following journal entry would be made:

• Debit: Cost of Goods Sold $10,000
• Credit: Manufacturing Overhead $10,000

This entry increases the cost of goods sold by $10,000, reflecting the fact that the actual overhead costs were higher than the amount that was applied to products.

Advantages of Using a Predetermined Overhead Rate

• Timely Cost Information: Provides cost information throughout the period, allowing for timely pricing decisions and performance evaluations.
• Smoother Costing: Smoothes out fluctuations in actual overhead costs, preventing erratic product costs.
• Improved Decision-Making: Facilitates better pricing, production, and inventory management decisions.
• Simplified Accounting: Simplifies the process of allocating overhead costs to products or jobs.

Disadvantages of Using a Predetermined Overhead Rate

• Reliance on Estimates: Based on estimates, which may not be accurate, leading to overapplied or underapplied overhead.
• Potential for Cost Distortion: If the allocation base is not chosen carefully, it can lead to cost distortion.
• Requires Careful Monitoring: Requires careful monitoring of actual costs and activity levels to identify and address any significant variances.

Predetermined Overhead Rate: A Real-World Example

Let's consider a small woodworking shop, "Fine Furnishings," that produces custom furniture. They want to determine their overhead rate for the upcoming year.

Step 1: Estimate Total Overhead Costs:

Fine Furnishings estimates the following overhead costs for the year:

• Rent: $12,000
• Utilities: $6,000
• Depreciation on Equipment: $8,000
• Indirect Labor: $14,000
• Factory Supplies: $2,000

Total Estimated Overhead Costs: $42,000

Step 2: Estimate Total Allocation Base:

Fine Furnishings decides to use direct labor hours as the allocation base. They estimate that their employees will work a total of 2,000 direct labor hours during the year.

Step 3: Calculate the Predetermined Overhead Rate:

Predetermined Overhead Rate = Estimated Total Overhead Costs / Estimated Total Allocation Base

Predetermined Overhead Rate = $42,000 / 2,000 Direct Labor Hours

Predetermined Overhead Rate = $21 per Direct Labor Hour

Applying the Rate:

If a specific custom table (Order #456) requires 20 direct labor hours, Fine Furnishings would apply overhead costs as follows:

Overhead Applied to Order #456 = Predetermined Overhead Rate x Actual Direct Labor Hours for Order #456

Overhead Applied to Order #456 = $21/Direct Labor Hour x 20 Direct Labor Hours

Overhead Applied to Order #456 = $420

Therefore, $420 of overhead costs would be applied to Order #456.

Key Takeaways and Best Practices

• Choose the Right Allocation Base: The allocation base should have a strong causal relationship with the overhead costs being allocated.
• Accurate Estimates: Strive for accurate estimates of both overhead costs and the allocation base. Review historical data and consider any expected changes in business conditions.
• Regular Monitoring: Regularly monitor actual costs and activity levels to identify and address any significant variances.
• Consider Activity-Based Costing (ABC): For more complex businesses with diverse products or services, consider using activity-based costing (ABC), which assigns overhead costs based on specific activities that drive those costs.

The Predetermined Overhead Rate and its role in Budgeting

The predetermined overhead rate plays a significant role in budgeting processes. Here's how:

• Budgeting Manufacturing Costs: It's used to budget the manufacturing costs for products. Companies use predetermined overhead rate to determine the overhead cost per unit and then project the total overhead cost based on the number of units to be produced.
• Flexible Budgeting: In flexible budgeting, the predetermined overhead rate can be used to adjust the budget based on actual production levels. If the actual production level differs from the initial estimate, the overhead cost can be adjusted using the predetermined rate.
• Variance Analysis: By comparing the overhead costs applied using the predetermined rate with the actual overhead costs, companies can perform variance analysis to identify the reasons for any discrepancies and take corrective action.

FAQ Section

• Q: Is the predetermined overhead rate always necessary?

  A: Not always. If a company has very low overhead costs or if its overhead costs are easily traceable to specific products or jobs, it may not need to use a predetermined overhead rate. However, for most manufacturing companies, it is a valuable tool for cost accounting and decision-making.

• Q: Can the predetermined overhead rate be adjusted during the year?

  A: It is generally not advisable to adjust the predetermined overhead rate during the year, as this can complicate the accounting process and make it difficult to compare costs across different periods. However, if there is a significant and unexpected change in overhead costs or activity levels, it may be necessary to revise the rate.

• Q: What is the difference between plant-wide overhead rate and departmental overhead rate?

  A: A plant-wide overhead rate uses a single allocation base for the entire factory, while departmental overhead rates use different allocation bases for each department. Departmental rates are more accurate when different departments have significantly different overhead costs and activity levels.

• Q: How does technology play a role in calculating and applying the predetermined overhead rate?

  A: Technology plays a crucial role in streamlining the process. ERP systems and accounting software can automate the calculation and application of the predetermined overhead rate, as well as track actual costs and activity levels. This can improve accuracy and efficiency.

Conclusion: Mastering Overhead Allocation

The predetermined overhead rate is a fundamental concept in cost accounting that enables businesses to allocate overhead costs to products or jobs in a timely and consistent manner. By understanding the formula, the importance of choosing the right allocation base, and the methods for dealing with overapplied or underapplied overhead, businesses can make more informed pricing, production, and inventory management decisions. While it relies on estimates and requires careful monitoring, the advantages of using a predetermined overhead rate often outweigh the disadvantages, making it a valuable tool for effective business management. By mastering the predetermined overhead rate, you unlock a clearer understanding of your true production costs and gain a competitive edge in the marketplace.