Predetermined Overhead Rate Calculation Explained
The predetermined overhead rate is a crucial tool for businesses to allocate manufacturing overhead costs to their products or services. This rate is established before the accounting period begins, using estimated figures. It helps in consistent product costing, pricing decisions, and inventory valuation. By applying a predetermined rate, companies can avoid the complexities of allocating actual overheads continuously throughout the period, which can fluctuate significantly.
How it's Calculated
The formula for the predetermined overhead rate is:
Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of Allocation Base
The "allocation base" is a measure that is believed to drive the incurrence of overhead costs. Common allocation bases include direct labor hours, direct labor costs, machine hours, or units produced. The choice of allocation base significantly impacts the accuracy of overhead allocation.
Why Use a Predetermined Rate?
- Timeliness: Allows for timely product costing and pricing decisions without waiting for actual year-end overhead figures.
- Stability: Provides a stable overhead rate throughout the period, smoothing out fluctuations caused by seasonal production or unexpected variations in overhead.
- Budgeting and Control: Facilitates better budgeting and control over manufacturing overhead costs.
Key Components
- Estimated Total Manufacturing Overhead Costs: This includes all indirect manufacturing costs anticipated for the period, such as indirect labor, factory rent, utilities, depreciation on factory equipment, and indirect materials.
- Estimated Total Amount of Allocation Base: This is the estimated total volume of the chosen allocation base for the period (e.g., total direct labor hours expected to be worked).
It's important to note that using a predetermined rate means that overhead applied to products will likely differ from actual overhead incurred. This difference is accounted for at the end of the period as either overapplied or underapplied overhead.