If you have a company related to manufacturing, or you work as an accountant for such a business, it’s essential to calculate and monitor the predetermined overhead rate. This rate helps monitor expenses to produce goods or provide services while setting a reasonable price to earn profit.
This rate also helps to determine when it’s time to review the company’s spending to protect its profit margins. Keep reading the article to learn more about the predetermined overhead rate and how to calculate and apply it.
Understanding Predetermined Overhead Rate
In accounting, a predetermined overhead rate is an allocation rate that applies a specific amount of manufacturing overhead to services or products. Typically, accountants estimate predetermined overhead at the beginning of each reporting period.
Accountants calculate the rate by dividing the total estimated manufacturing overhead costs by an allocation base (also known as the activity driver). Here are some of the most commonly used activity drivers or allocation bases:
- machine hours;
- direct materials;
- direct labor hours;
- direct labor dollars.
Typically, companies use this rate to close the books more quickly. The rate avoids collecting actual manufacturing overhead costs as part of the closing period.
Note: an accountant must determine the difference between the estimated and actual amounts of overhead by the end of each fiscal year. It’s even recommended to calculate the difference more frequently. Now let’s dive into the details of the formula and calculation of this rate.
The formula includes the following components:
- Estimated manufacturing overhead costs / estimated total units in allocation base = predetermined overhead rate.
Now let’s take a look at calculating the rate in detail.
How To Calculate Predetermined Overhead Rate?
The predetermined overhead rate is determined by dividing the pre-calculated manufacturing overhead cost by the activity driver. Here’s an example: when the activity driver is machine-hours, then the accountant should divide overhead costs by the calculated number of machine-hours. Follow the short instruction to calculate overhead costs.
Determine Estimated Manufacturing Overhead Costs
Manufacturing overhead costs are expenses related to overhead costs that result from producing products. Typically, manufacturing overhead costs include:
- facility maintenance;
- equipment depreciation;
- factory supplies.
In some cases, the accountant could include employees’ salaries or wages in this list. Note: include employees’ salaries or wages only if these employees are directly involved in goods production. Here are a few examples:
- factory supervisors;
- maintenance workers;
- cleaning crews.
Do not add office workers’ salaries. When you determine all company’s manufacturing overhead costs, add them to get the total.
Determine The Estimated Activity Driver (Allocation Base)
As mentioned in the article, accountants may use machine hours, direct labor hours or dollars, etc., as the allocation base. Suppose a business is focused on auto repair, then the accountant has to use direct labor hours in their calculation to determine how many hours it took for a mechanic to do their job.
If a factory is producing some goods, the accountant should determine the number of hours a machine uses during the activity period.
Determine Predetermined Overhead Rate
Now that all parts of the equation are determined let’s calculate the predetermined overhead rate. Divide the estimated manufacturing overhead costs by the activity driver.
Let’s assume a company has $32,000 as manufacturing overhead costs and 7,000 as machine hours. In this case, the company’s predetermined overhead rate is $4.57 per unit.
Predetermined Overhead Rate Example
A company XYZ manufactures a product ABC. XYZ uses its labor hours to assign the manufacturing overhead cost. The accountant has calculated estimated manufacturing overhead expenses: $325,000. The estimated labor hours are 3,100 hours. The next step is to calculate a predetermined overhead rate:
$325,000 / 3,100 = 104,8
So, the predetermined overhead rate is 104,8 per direct labor hour.
Issues With Predetermined Overhead Rates
Accounting differentiates several concerns related to using a predetermined overhead rate. To name a few:
- Possibly unrealistic results. The numerator and denominator in the equation consist of estimates, so the calculation results may not be accurate.
- Causes variance recognition problems. The difference between predetermined and actual overhead amounts can be charged expense in the current period. As a result, it may cause a material change in the profit amount and inventory asset.
- Has a weak link to historical costs. It may be impossible to figure out the manufacturing overhead amount using historical data because of sudden increases and decreases in costs.
- Faulty sales and production decisions. Since sometimes calculations could be based on inaccurate data, these results may negatively impact the management’s decisions.
Companies should be very careful when using the predetermined overhead rate to make decisions. It is recommended to use other mechanisms to make wise decisions.
Use Cases Of Predetermined Overhead Rate
As mentioned, the business could use this rate to close the books. But there are other use cases:
- Tracking relative expenses. This rate provides businesses with a percentage they could track regularly (each quarter, month, or even week). The rate could help companies or their management ensure expenses aren’t escalating in the future.
- Tracking overhead rate. A business could regularly estimate actual expenses and then compare those to the predetermined overhead rate to track costs throughout a specific period (usually, year).
- Setting prices. It’s easier to set accurate prices on products or services when knowing overhead costs per unit or labor hour.
- Closing the books. Companies utilize this rate as an aid to close their books more quickly since it enables them to avoid collecting actual overhead costs as part of their closing process.
With the aid of this rate, companies may set prices on their products or services and ensure their expenses won’t go overboard.
Author: Charles Lutwidge