4 4: Compute a Predetermined Overhead Rate and Apply Overhead to Production Business LibreTexts

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. The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The overhead is then applied to the cost of the product from the manufacturing overhead account.

• You should calculate your predetermined overhead rate at least once per year.
• 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.
• On the other hand, if the business wants to use actual overheads, it has to wait for the end of the month and get invoices in hand.
• Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units.

Example 2: ecommerce business

• A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory.
• A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs.
• Once an overhead rate is calculated using the given formula, it’s absorbed in the cost card of the business using the actual level of the activity.
• For example, let’s say the marketing agency quotes a client $1,000 for a project that will take 10 hours of work.
• 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.
• 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.

The rate is determined by dividing the fixed overhead cost by the estimated number of direct labor hours. The production manager has told us that the manufacturing overhead will be $ 500,000 for the whole year and the company expected to spend 20,000 hours on direct labor. The management concern about how to find a predetermined overhead rate for costing. The predetermined overhead rate formula is calculated by dividing the total estimated overhead costs for the period by the estimated activity base. This rate is useful from the point of view of cost control as it enables management to plan ahead and budget for the future. The application rate that will be used in a coming period, such as the next year, is often estimated months before the actual overhead costs are experienced.

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Then, they’ll need to estimate the amount of activity or work that will be performed in that same time period. For this example, we’ll say the marketing agency estimates that it will work 2,500 hours in the upcoming year. Fixed costs are those that remain the same even when production or sales volume changes.

What is the right basis to use to calculate the overhead rate

The computation of the overhead cost per unit for all of the products is shown in Figure 6.4. Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity. The predetermined overhead rate is based on the anticipated amount of overhead and the anticipated quantum or value of the base.

Businesses normally face fluctuation in product demand due to seasonal variations. Fixed overheads are expected to increase/decrease per unit in line with the seasonal variations. So, the cost of a product in one period may not reflect the cost in another period—for instance, the cost of freezing fish increases in the summer and lowers in the winter. However, there is a strong need to constantly update the production level depending on the seasonal fluctuations and the factor affecting the demand of the product. However, if there is a difference in the total overheads absorbed in the cost card, the difference is accounted for in the financial statement.

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In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC).

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The overhead used in the allocation is an estimate due to the timing considerations already discussed. Let’s assume a company has overhead expenses that total $20 million for the period. The company has direct labor expenses totaling $5 million for the same period. The production head wants to calculate a predetermined overhead rate, as that is the main cost allocated to the new product VXM. A Predetermined Overhead rate shall be used to calculate an estimate on the projects that are yet to commence for overhead costs.

Finance Strategists has an advertising relationship with some of the companies included on this website. We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. Suppose following are the details regarding indirect expenses of the business. This information can help you make decisions about where to cut costs or how to allocate your resources more efficiently. Once you have a good handle on all what is the predetermined overhead rate the costs involved, you can begin to estimate how much these costs will total in the upcoming year.

A number of possible allocation gross vs net bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours. We can calculate predetermined overhead for material using units to be allocated. For example, we can use labor hours worked, and for calculating overhead for the store department, we can use the quantity of material to be used.