Understanding the Predetermined Overhead Rate
In cost accounting, businesses need to allocate manufacturing overhead costs to the products they produce. These overhead costs are indirect expenses associated with production, such as factory rent, utilities, indirect labor (supervisors, maintenance staff), depreciation of machinery, and factory supplies. Because these costs are indirect, they cannot be directly traced to a specific unit of product. Therefore, a systematic method is required to distribute these costs.
What is the Predetermined Overhead Rate?
The predetermined overhead rate (POR) is an estimated overhead rate calculated before a period begins. It's used to apply overhead costs to products or services throughout that period. This rate is crucial for several reasons:
- Timely Costing: It allows for the costing of products as they are manufactured, rather than waiting until the end of the accounting period when actual overhead costs are known. This is vital for inventory valuation and pricing decisions.
- Smooths Out Fluctuations: Actual overhead costs can fluctuate significantly due to seasonal production or irregular events. Using a predetermined rate helps to absorb overhead costs evenly throughout the period, preventing distortions in product costs.
- Budgeting and Planning: The process of calculating the POR involves estimating both overhead costs and an allocation base, which aids in budgeting and financial planning.
How to Calculate the Predetermined Overhead Rate
The formula for calculating the predetermined overhead rate is straightforward:
Predetermined Overhead Rate = Total Estimated Manufacturing Overhead / Total Estimated Allocation Base
In this calculator, we are using Total Estimated Direct Labor Costs as the allocation base. This is a common allocation base, especially in labor-intensive industries. Other common allocation bases include machine hours, direct labor hours, or units produced. The choice of allocation base depends on which best drives the incurrence of overhead costs in a particular business.
Steps to Calculate:
- Estimate Total Manufacturing Overhead: At the beginning of the period, forecast all anticipated indirect manufacturing costs for that period. This includes items like indirect materials, indirect labor, factory rent, utilities, insurance, and depreciation.
- Estimate the Allocation Base: Forecast the total expected amount of the chosen allocation base for the period. If using direct labor costs, this means estimating the total cost of direct labor that will be incurred.
- Divide: Divide the total estimated manufacturing overhead by the total estimated allocation base. The result is the predetermined overhead rate, often expressed as a percentage or a dollar amount per unit of the allocation base.
Example Calculation
Let's say a company estimates the following for the upcoming year:
- Total Estimated Manufacturing Overhead: $150,000
- Total Estimated Direct Labor Costs: $200,000
Using the calculator or the formula:
Predetermined Overhead Rate = $150,000 / $200,000 = 0.75
To express this as a percentage, multiply by 100:
Predetermined Overhead Rate = 0.75 * 100 = 75%
This means that for every dollar of direct labor cost incurred, the company will apply $0.75 (or 75%) of manufacturing overhead to the cost of the product. If a specific job requires $500 in direct labor costs, $375 ($500 * 75%) of overhead would be applied to that job.
Why is it Important?
A well-calculated predetermined overhead rate is fundamental for accurate product costing, which directly impacts pricing strategies, profitability analysis, and inventory valuation on financial statements. While it's an estimate, the goal is to make it as accurate as possible by using reliable forecasts and selecting an appropriate allocation base that logically drives overhead costs.