Predetermined Overhead Rate Calculator
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Understanding the Predetermined Overhead Rate
The predetermined overhead rate is a crucial concept in managerial accounting, allowing businesses to allocate manufacturing overhead costs to products or services in a systematic and timely manner. Instead of waiting until the end of an accounting period to determine actual overhead costs and then allocating them (which can be too late for effective decision-making), companies use an estimated rate at the beginning of the period.
How is the Predetermined Overhead Rate Calculated?
The formula for calculating the predetermined overhead rate is straightforward:
Predetermined Overhead Rate = Total Estimated Manufacturing Overhead Costs / Total Estimated Allocation Base
Key Components:
- Total Estimated Manufacturing Overhead Costs: This includes all anticipated indirect manufacturing costs for the period. Examples include estimated factory rent, utilities, indirect labor (supervisors, maintenance staff), depreciation on factory equipment, and indirect materials. These estimates are typically based on historical data, budgets, and forecasts.
- Total Estimated Allocation Base: This is a measure of activity that is expected to drive overhead costs. Common allocation bases include direct labor hours, direct labor costs, machine hours, or units produced. The chosen allocation base should have a strong correlation with the overhead costs being incurred.
Once the overall rate is determined, it can be applied to products or services based on the actual amount of the allocation base used by each product. For instance, if the allocation base is direct labor hours, the overhead allocated to a specific job would be:
Overhead Allocated to Job = Predetermined Overhead Rate × Actual Amount of Allocation Base Used by the Job
A variation often needed is the overhead rate per unit. This is useful for pricing and cost control. It is calculated as:
Overhead Rate Per Unit = Predetermined Overhead Rate / Allocation Base Per Unit
Why Use a Predetermined Overhead Rate?
- Timeliness: It allows for the assignment of overhead costs to products as they are produced, providing up-to-date cost information for pricing, inventory valuation, and performance evaluation.
- Smoothing: It smooths out fluctuations in overhead costs that might occur due to seasonality or variations in production levels. Actual overhead costs might vary significantly from month to month, but the predetermined rate provides a stable cost basis.
- Planning and Control: It aids in budgeting and cost control by setting an expected rate against which actual costs can be compared.
It's important to note that the predetermined overhead rate is an estimate. At the end of the accounting period, actual overhead costs are compared to the overhead costs applied using the predetermined rate. Any difference is referred to as an overhead variance (either overapplied or underapplied overhead) and is typically adjusted to the Cost of Goods Sold or allocated among Work-in-Process, Finished Goods, and Cost of Goods Sold.
Example Calculation:
Let's say a company estimates its total manufacturing overhead costs for the next year to be $500,000. The company also estimates that it will use 10,000 direct labor hours as its allocation base. The allocation base per unit for a particular product is 2 direct labor hours.
- Total Estimated Manufacturing Overhead Costs = $500,000
- Total Estimated Allocation Base (Direct Labor Hours) = 10,000 hours
- Allocation Base Per Unit (Direct Labor Hours) = 2 hours/unit
Predetermined Overhead Rate = $500,000 / 10,000 direct labor hours = $50 per direct labor hour.
Overhead Rate Per Unit = $50 per direct labor hour / 2 direct labor hours per unit = $25 per unit.
This means the company will allocate $50 of overhead for every direct labor hour worked on a product, or $25 of overhead for each unit produced (assuming 2 direct labor hours per unit).