How to Calculate a Predetermined Overhead Rate

Predetermined Overhead Rate Calculator

Understanding Predetermined Overhead Rates

A predetermined overhead rate is a crucial tool for businesses, particularly in manufacturing and service industries, to efficiently allocate indirect costs (overhead) to products or services. Unlike actual overhead rates, which are calculated after a period has ended using actual incurred costs and actual activity levels, a predetermined overhead rate is estimated before the period begins. This allows for more consistent product costing, budgeting, and decision-making throughout the accounting period.

Why Use a Predetermined Overhead Rate?

Using a predetermined rate offers several advantages:

• Timely Product Costing: Businesses can assign overhead costs to products as they are manufactured or services are rendered, providing more up-to-date cost information.
• Smoothes Fluctuations: It avoids the distortions that can arise from seasonal or irregular overhead cost fluctuations, leading to more stable product costs.
• Budgeting and Planning: The predetermined rate facilitates budgeting and helps in planning for future production or service delivery.
• Performance Evaluation: It allows for variance analysis by comparing applied overhead (based on the predetermined rate) with actual overhead incurred.

How to Calculate a Predetermined Overhead Rate

The formula for a predetermined overhead rate is straightforward:

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

Let's break down the components:

• Total Estimated Overhead Costs: This includes all indirect costs that cannot be directly traced to a specific product or service. Examples include factory rent, utilities, indirect labor (supervisors, maintenance staff), depreciation of factory equipment, and factory supplies. These costs must be carefully estimated for the upcoming accounting period (e.g., a year).
• Total Estimated Activity Base: This is the measure of activity that is expected to drive overhead costs. Common activity bases include:
  • Direct labor hours
  • Direct labor costs
  • Machine hours
  • Units produced
  The most appropriate activity base is one that has a strong correlation with the incurrence of overhead costs. For example, if machine usage is the primary driver of overhead, machine hours would be a suitable base. In this calculator, we're using Direct Labor Hours as the activity base.

Applying the Predetermined Overhead Rate

Once calculated, the predetermined overhead rate is applied to products or services based on the actual amount of the activity base consumed. For instance, if the predetermined rate is $20 per direct labor hour and a specific job or product required 5 direct labor hours, $100 ($20 x 5) of overhead would be allocated to that job or product.

Example Calculation

Suppose a company estimates its total overhead costs for the upcoming year to be $100,000. The company also estimates that it will incur a total of 5,000 direct labor hours throughout the year.

• Total Estimated Overhead Costs = $100,000
• Total Estimated Direct Labor Hours = 5,000 hours

Using the formula:

Predetermined Overhead Rate = $100,000 / 5,000 hours = $20 per direct labor hour.

This means the company will allocate $20 of overhead cost for every direct labor hour worked on its products or services.