In a company, the management wants to calculate the predetermined overhead to set aside some amount for the allocation of a cost unit. Therefore, they use labor hours for the apportionment of their manufacturing cost. Small companies tend to use activity-based costing, whereas in larger companies, each department in which different processes of production take place typically computes its own predetermined overhead rate. Hence, the overhead incurred in the actual production process will differ from this estimate. In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments.

The production head wants to calculate a predetermined overhead rate, as that is the main cost allocated to the new product VXM. The overhead cost per unit from Figure 6.4 is combined with the direct material and direct labor costs as shown in Figure 6.3 to compute the total cost per unit as shown in Figure 6.5. Establishing a predetermined overhead rate for your business can give you a tool to help keep expenses in proportion with sales and production volumes.

Larger organizations employ different allocation bases for determining the predetermined overhead rate in each production department. However, in recent years the manufacturing operations have started to use machine hours more predominantly as the allocation base. Commonly, the manufacturing overhead cost for machine hours can be ascertained from the predetermined overhead rate in the manufacturing industry. Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals. Suppose that X limited produces a product X and uses labor hours to assign the manufacturing overhead cost.

## Measuring Expenses to a Corresponding Base

The company estimates a gross profit of \$100 million on total estimated revenue of \$250 million. As per the budget, direct labor cost and raw material cost for the period is expected to be \$40 million and \$60 million respectively. The company uses machine hours to assign manufacturing overhead costs to products. Calculate the predetermined overhead rate of GHJ Ltd if the required machine hours for next year’s production is estimated to be 10,000 hours.

Monitoring a well-defined rate provides a quick signal that lets you know when it’s time to review spending and, in doing so, will help you protect your profit margins. A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours. For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients. Based on the manufacturing process, it is also easy to determine the direct labor cost. But determining the exact overhead costs is not easy, as the cost of electricity needed to dry, crush, and roast the nuts changes depending on the moisture content of the nuts upon arrival. The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed.

## Sales and Production Decisions are Faulty

To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too. Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner. If you’d like to learn more about calculating rates, check out our in-depth interview with Madison Boehm. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.

Any difference between applied overhead and the amount of overhead actually incurred is called over- or under-applied overhead. Thus the organization gets a clear idea of the expenses allocated and the expected profits during the year. The concept of predetermined overhead is based on the assumption that the overheads will remain constant, and the production value is dependent on it. It helps to improve the segregation of the costs to their respective cost centers, thus making it a helping tool if used properly by the organization and if the calculations are correct after taking somewhat accurate assumptions.

However, one major disadvantage of the method is that both the numerator and the denominator are estimates and as such, it is possible that the actual result may vary significantly from the predetermined overhead rate. We can calculate predetermined overhead for material using units to be allocated. For example, we can use labor hours worked, and for calculating overhead for the store department, we can use the quantity of material to be used.

In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation. Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. Overhead costs are incurred whether the company is producing a large or small quantity of products or services. This concept is important because these costs must be estimated in order to properly provide accurate prices to future customers.

The more historical data that a company has, the better off that they will be when computing predetermined rates. It is also possible (and often recommended) for a company to use different methods depending on the specific products, processes, and services within the organization. Predetermined overheads rate is the ratio of estimated overhead cost to the estimated units to be allocated and is used for allocation of expenses across its cost centers and can be fixed, variable or semi-variable. Before the beginning of any accounting year, it is determined to estimate the level of activity and the amount of overhead required to allocate the same.

An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be. As a result, management would likely view labor hours as the activity base when applying overhead costs. The controller of the Gertrude Radio Company wants to develop a predetermined overhead rate, which she can use to apply overhead more quickly in each reporting period, thereby allowing for a faster closing process. A later analysis reveals that the actual amount that should have been assigned to inventory is \$48,000, so the \$2,000 difference is charged to the cost of goods sold.

• This activity base is often direct labor hours, direct labor costs, or machine hours.
• The allocation base includes direct labor costs, direct labor dollars, or the number of machine-hours.
• The predetermined overhead rate calculation shown in the example above is known as the single predetermined overhead rate or plant-wide overhead rate.

For example, if ABC Manufacturing’s actual manufacturing overhead was \$100,000 but their applied manufacturing overhead was only \$60,000, they underapplied \$40,000. Conversely, if the actual manufacturing overhead was \$100,000 but their applied manufacturing overhead was \$120,000, they overapplied by \$20,000. Hence, preliminary, company A could be the winner of the auction even though the labor hour used by company B is less, and units produced more only because its overhead rate is more than that of company A. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too.

Using the formula, you divide the total overhead cost (\$553,000) by the activity base (\$316,000), we get an allocation rate of 1.75 (175%). In this case, these numbers are not estimated because they are historical figures. A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year. The predetermined overhead rate formula is calculated by dividing the estimated manufacturing overhead cost by the allocation base.

Further, the company uses direct labor hours to assign manufacturing overhead costs to products. As per the budget, the company will require 150,000 direct labor hours during the forthcoming year. Based on the given information, calculate the predetermined overhead rate of TYC Ltd. One such limitation is that the estimated overhead rate is not always realistic. Since the rate is based solely on estimates and not confirmed costs, the end results may not always match the actual manufacturing overhead rates.

If overhead is overestimated, then prices will be too high and that can cause customers to seek their products or services from other companies (most likely their competitors). If overhead is underestimated, then the company may set their prices too low and not earn profits or experience a loss. If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions. Company B wants a predetermined rate for a new product that it will be launching soon. Its production department comes up with the details of how much the overheads will be and what other costs will be incurred.

## Reasons for Predetermined Overhead Rate

Instead of using a pre-determined rate based on estimates, why not base the overhead rate on the actual total manufacturing overhead cost and the actual total amount of the activity base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs.

This is related to an activity rate which is a similar calculation used in Activity-based costing. A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead. Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units.

To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems.

At a later stage, when the actual expenses are known, the difference between that allocated overhead and the actual expense is adjusted. Overhead rate is a percentage used to calculate an estimate for overhead costs on projects that have not yet started. It involves taking a cost that is known (such as the cost of materials) and then applying a percentage (the predetermined overhead rate) to it in order to estimate a cost that is not known (the overhead amount). Larger organizations may employ a different predetermined overhead rate in each production department, which tends to improve the accuracy of overhead application by employing a higher level of precision. However, the use of multiple predetermined overhead rates also increases the amount of required accounting labor.