Predetermined Overhead Rate

What is predetermined overhead rate? – Definition:

A predetermined overhead rate is an allocation rate that is given for indirect manufacturing costs that are involved in the production of a product or various products. It is used to estimate the manufacturing costs that will take place. The estimation takes place at the beginning of an accounting period, before the commencement of any projects or specific jobs for which the rate is needed.

Formula to calculate predetermined overhead rate:

This rate is derived using the following formula:

Predetermined-overhead-rate-formula

Explanation:

This formula of the predetermined overhead rate is purely based on estimates. Hence the overhead incurred in the actual production process would be different from this estimate. This difference is calculated at the end of the accounting period. This difference is known as either over-absorption or under-absorption of overheads.


 

The allocation base (also known as activity base or activity driver) can differ depending on the nature of the costs involved. The common allocation bases are direct labor hours, direct labor cost, machine hours, and direct materials. To further understand the formula, we can have a look at the following steps:

  1. Figure out different overhead costs involved and the total amount.
  2. Decide which costs are the same in nature and have a relationship with the different allocation bases.
  3. Determine which allocation base will be for which department (incase of various departments).
  4. Then take the total overheads cost and divide by the allocation base determined.
  5. The rate calculated in step 4 can either be used for other departments or new rates for other departments can be computed using these same steps.
Also Check:  Overhead absorption

Departmental overhead rates are needed because production has different processes that take place in different departments.

 Example:

The following example can help us understand the calculation better:

Company B wants a pre-determined rate for the product it will be launching soon. The production department comes up with the details of how much the overheads will be and what other costs will be incurred. The pricing details are as follows:


ItemBaseAmount
Direct LaborBased on labor hours200,000
Direct MaterialBased on material units250,000
Variable overheadBased on labor hours150,000
Fixed overheadBased on labor hours350,000
Direct labor hours2000 

Since we are required to calculate the pre-determined rate, the direct costs will be ignored. The total manufacturing overhead cost will be variable overhead plus fixed overhead. 150,000+350,000=500,000

Total Manufacturing Overhead = 500,000

Labor hours are 2000. So the predetermined rate would be= Total Manufacturing Overhead/Direct Labor hours = 500,000/2,000= 250 per direct labor hour.

So this rate of 250 will be used in the pricing of the new product.

If we change the allocation base to machine hours, the predetermined rate would be based on machine hours. For example:

ItemBaseAmount
Direct LaborBased on labor hours200,000
Direct MaterialBased on material units250,000
Variable overheadBased on labor hours150,000
Fixed overheadBased on labor hours350,000
Direct labor hours1000 
Direct Machine hours4500 
Also Check:  Blanket Absorption Rate and Departmental Absorption Rate

 Manufacturing Overhead/Direct machine hours = 500,000/4,500 = 111.11 per direct labor hour.

The predetermined overhead rate’s calculation shown in the example above is known as single predetermined overhead rate or plant-wide overhead rate. Different businesses have different ways of costing; some use single rate, other’s multiple rates and the rest use activity-based-costing. Mostly the small companies use it. In larger companies, each department where different processes of production take place, they compute their own predetermined overhead rate. Even though it may become more complex to have different rates for each department, it is still considered more accurate and helpful to have different rates as the level of efficiency and precision increases.

Concerns:

However, there are many things to think about in using a predetermined rate.

The rates aren’t realistic as they are based on accounting estimates. The production hasn’t taken place and is completely based on forecasts or previous accounting records, and the actual overheads incurred could turn out to be way different than the estimate. Also if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate too. This can result in abnormal losses as well and unexpected expenses being incurred. Unexpected expenses can be a result of a big difference between actual and estimated overheads. Profits will be affected and assets may need to be worked beyond their capacity too. Furthermore, historical data is not always the best for predicting, estimating and forecasting. Prices increase all the time and industry trends and consumer’s expectations are constantly changing.

Also Check:  Departmentalization of Overheads

To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration too.

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