Predetermined Overhead Rate Calculator
How the Predetermined Overhead Rate is Calculated
The predetermined overhead rate (POHR) is a crucial metric in managerial accounting, specifically within job-order costing systems. It allows manufacturers and service providers to estimate the overhead costs associated with a specific job or product before the actual costs are known at the end of the accounting period.
This calculation helps businesses normalize the fluctuations in overhead costs (like seasonal utility bills) and production volume, ensuring that product pricing and costing remain consistent throughout the year.
The Formula
The predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead costs by the estimated total amount of the allocation base. This calculation is performed before the period begins (typically at the start of the fiscal year).
Components of the Calculation
- Estimated Total Manufacturing Overhead Costs: This is the sum of all indirect manufacturing costs expected for the upcoming period. It includes indirect materials, indirect labor, factory rent, utilities, depreciation on factory equipment, and insurance. It does not include direct materials or direct labor.
- Allocation Base: This is the driver used to assign overhead costs to products. It should be the factor that most heavily influences or "drives" the overhead costs. Common bases include:
- Direct Labor Hours: Used when labor is the primary driver of production activity.
- Machine Hours: Used in highly automated environments where machinery drives costs.
- Direct Labor Cost: Used when overhead rates are correlated with the wages paid to workers.
Example Calculation
Consider a furniture manufacturing company, "FineWoodworks," preparing its budget for the upcoming year.
- The company estimates total manufacturing overhead costs (rent, glue, supervisor salaries, electricity) will be $600,000.
- Because the work is labor-intensive, they choose Direct Labor Hours as their allocation base.
- They estimate they will use 30,000 Direct Labor Hours during the year.
Using the formula:
POHR = $600,000 / 30,000 hours = $20.00 per Direct Labor Hour
This means that for every hour a carpenter works on a table, the company will add $20 to the cost of that table to cover overhead expenses.
Why Not Use Actual Rates?
You might wonder why companies use estimates instead of actual data. The predetermined overhead rate is calculated using estimates because actual overhead costs are not known until the end of the period. If a company waited for actual data, they would not be able to cost jobs or price products accurately as they are completed. Furthermore, actual overhead rates can fluctuate wildly month-to-month due to seasonal heating costs or repair bills, which would cause the unit cost of identical products to vary simply based on the month they were produced.
Calculating Applied Overhead
Once the rate is established, it is used to "apply" overhead to work-in-process inventory. The formula for applied overhead is:
Applied Overhead = Predetermined Overhead Rate × Actual Amount of Allocation Base Used
If a specific custom desk job took 15 direct labor hours to complete, using the example above ($20/hr), the applied overhead for that desk would be $300.