Monday, April 15, 2024

How to Calculate a Predetermined Overhead Rate

Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base. An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be. As a result, management would likely view labor hours as the activity base when applying overhead costs. Using a predetermined overhead rate allows companies to apply manufacturing overhead costs to units produced based on an estimated rate, rather than actual overhead costs. This rate is then used throughout the period and adjusted at year-end if necessary based on actual overhead costs incurred.

The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The expected overhead is estimated, and an allocation system is determined. The overhead is then applied to the cost of the product from the manufacturing overhead account.

  1. Additionally, you should recalculate your predetermined overhead rate any time there is a significant change in your business, such as the addition of new equipment or a change in your product line.
  2. Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization.
  3. Businesses rely on the predetermined overhead rate to accurately estimate costs, set competitive prices, and make informed financial decisions.
  4. The predetermined overhead rate allocates estimated total overhead for an accounting period across expected activity or production volume.
  5. Last fiscal year, the total overhead cost was $553,000, and direct materials cost was $316,000.

Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Furthermore, historical data is not always the best for predicting, estimating, and forecasting. This can result in abnormal losses as well and unexpected expenses being incurred.

Allocation bases (such as direct labor, direct materials, machine hours, etc.) are used when finding a relationship with total overhead costs. The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor. Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation. Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor. To calculate the predetermined overhead rate, it’s vital to understand its components, including estimated indirect costs and the chosen allocation base, often measured in direct labor hours. There are some limitations and problems with the predetermined overhead rate.

Generally speaking, small businesses calculate their overhead rate annually, although they can and do use shorter periods, depending on the allocation measure they’re using. With the aid of this rate, companies may set prices on their products or services and ensure their expenses won’t go overboard. Companies should be very careful when using the predetermined overhead rate to make decisions. There are several concerns with using a predetermined overhead rate, which include are noted below.

Knowing the overhead cost per unit allows the business to set competitive pricing while still covering their indirect expenses. By factoring in overhead costs in this manner, the company arrives at a more accurate COGS. The key is choosing an appropriate cost driver – like machine hours in manufacturing or headcount in sales – to distribute overhead expenses. Allocating overhead this way provides better visibility into how much overhead each department truly consumes. Calculating overhead rates accurately is critical, yet often confusing, for businesses.

Overhead Rate Calculation: Accounting Explained

Indirect costs are those that cannot be easily traced back to a specific product or service. For example, the office rent mentioned earlier can’t be directly linked to any one good or service produced by the business. The movie industry uses job order costing, and studios need to allocate overhead to each movie. Their amount of allocated overhead is not publicly known because while publications share how much money a movie has produced in ticket sales, it is rare that the actual expenses are released to the public. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved.

Once you have a handle on your estimated overhead costs, you can plug these numbers into the formula to calculate your predetermined overhead rate. A predetermined overhead rate is a useful tool for businesses of all sizes. By understanding how to calculate this rate, business owners can better control their overhead costs and make more informed pricing decisions. Predetermined overhead rates are essential to understand for eCommerce businesses as they can be used to price products or services more accurately.

To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems.


Businesses should understand which overhead costs are fixed vs variable when budgeting and setting overhead rates. So in summary, the overhead rate formula relates your indirect operating costs to production costs. Yes, it’s a good idea to have predetermined overhead rates for each area of your business. Now, let’s look at some hypothetical business models to see actual use-cases for predetermined overhead rates.

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Since overhead costs cannot be easily traced to individual products like direct material or labor costs, overhead rates help to allocate a fair share of these costs based on the activity of making the product. This allows businesses to capture the full cost of production in their accounting. You and the other managers at XYZ, Inc. have reviewed the historical overhead rates within your division and found that there is a link between the amount spent on materials to make your product and the total overhead. Last fiscal year, the total overhead cost was $553,000, and direct materials cost was $316,000.

This rate also helps to determine when it’s time to review the company’s spending to protect its profit margins. Keep reading the article to learn more about the predetermined overhead rate and how to calculate and apply it. The use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or promotional giveaways for not decline in these costs. This is a particular concern in highly competitive industries where production rates may vary dramatically, based on the popularity of the latest round of product releases. Accurate predetermined overhead rate calculations offer a myriad of benefits, from improved financial forecasting to better decision-making processes.

Analyzing overhead rates by department in this manner helps identify problem areas and opportunities to improve profitability. This comprehensive guide breaks down overhead rate calculation into clear, actionable steps any business can follow. Conversely, the cost of the t-shirts themselves would not be considered overhead because it’s directly linked to your product (and obviously changes based on the volume of products you create and sell).

For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied. When the $700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is $5.00 per unit. The computation of the overhead cost per unit for all of the products is shown in Figure 6.4.

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