Show
What is a Predetermined Overhead Rate?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. 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. How to Calculate a Predetermined Overhead RateThe predetermined rate is derived using the following calculation: Estimated amount of manufacturing overhead to be incurred in the period ÷ Estimated allocation base for the period A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours. Example of a Predetermined Overhead RateThe 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. For this calculation, she uses the average manufacturing overhead cost for the past three months, and divides by the estimated amount of machine hours to be used in the current month, based on the most recent production schedule for the period. This results in $50,000 being allocated to inventory in the period. 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. Problems with Predetermined Overhead RatesThere are several concerns with using a predetermined overhead rate, which include are noted below. Overhead Rate is Not RealisticSince both the numerator and denominator of the calculation are comprised of estimates, it is possible that the result will not bear much resemblance to the actual overhead rate. Sales and Production Decisions are FaultyIf 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. Variance Recognition ProblemsThe difference between the actual and predetermined amounts of overhead could be charged to expense in the current period, which may create a material change in the amount of profit and inventory asset reported. Weak Link to Historical CostsThe use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or decline in these costs.  Predetermined Overhead Rate Formula (Table of Contents)
The term “predetermined overhead rate” refers to the allocation rate that is assigned to products or job orders at the beginning of a project based on the estimated cost of manufacturing overhead for a specific period of reporting. In other words, it provides an estimate of the expected cost to be incurred in producing a product or job order. The formula for the predetermined overhead rate can be derived by dividing the estimated manufacturing overhead cost by the estimated number of units of the allocation base for the period. Typically, direct labor cost, direct labor hours, machine hours or prime cost is used as the allocation base, while the period usually selected is one year. Mathematically, it is represented as, Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period Examples of Predetermined Overhead Rate Formula (With Excel Template)Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner. Predetermined Overhead Rate Formula – Example #1Let us take the example of a company named TYC Ltd that is engaged in the business of manufacturing automotive spare parts for two-wheelers. The company has budgeted the following cost for the upcoming year: 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. Solution: From the above list, salaries of floor managers, factory rent, depreciation and property tax form part of manufacturing overhead. Estimated Manufacturing Overhead Cost is calculated using the formula given below Estimated Manufacturing Overhead Cost = Salaries of Managers + Factory Rent + Depreciation + Property Tax
Predetermined Overhead Rate is calculated using the formula given below Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period
Therefore, the predetermined overhead rate of TYC Ltd for the upcoming year is expected to be $320 per hour. Predetermined Overhead Rate Formula – Example #2Let us take the example of ort GHJ Ltd which has prepared the budget for next year. 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. Solution: Estimated Manufacturing Overhead Cost is calculated using the formula given below Estimated Manufacturing Overhead Cost = Total Estimated Revenue – Gross Profit – Direct Labor Cost – Raw Material Cost
Predetermined Overhead Rate is calculated using the formula given below Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period
Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour. ExplanationThe formula for the predetermined overhead rate can be derived by using the following steps: Step 1: Firstly, determine the level of activity or the volume of production in the upcoming period. Step 2: Next, determine the estimated manufacturing overhead cost for that level of activity in the forthcoming period. It includes all the indirect costs that are expected to be incurred in the process of production, however the same can’t be assigned directly to the product. Step 3: Next, decide on the allocation base for the period, which can be direct labor cost, direct labor hours, machine hours or prime cost. Step 4: Next, determine the estimated number of units of the allocation base for the upcoming period, which will be either in terms of hours for direct labor hours and machine hours or dollars for direct labor cost and prime cost. Step 5: Finally, a formula for predetermined overhead rate can be derived by dividing the estimated manufacturing overhead cost (step 2) by the estimated number of units of the allocation base for the period (step 4) as shown below. Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period Relevance and Uses of Predetermined Overhead Rate FormulaThe concept of predetermined overhead rate is very important because it is used most of the enterprises as it enables them to estimate the approximate total cost of each job. 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. 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. Predetermined Overhead Rate Formula CalculatorYou can use the following Predetermined Overhead Rate Formula Calculator
Recommended ArticlesThis is a guide to the Predetermined Overhead Rate Formula. Here we discussed how to calculate Predetermined Overhead Rate Formula along with practical examples. We also provide a Predetermined Overhead Rate calculator with a downloadable excel template. You may also look at the following articles to learn more –
Which of the following is the formula to calculate the predetermined factory overhead rate?The answer is a) Estimated total factory overhead costs divided by estimated activity base. The predetermined overhead rate formula is: Predetermined overhead rate = Estimated overhead costs / Estimated allocation base.
What is the formula for allocation rate?Calculate Overhead Allocation Rate
This is done by dividing total overhead by the number of direct labor hours. This means for every hour needed to make a product, you need to allocate $3.33 worth of overhead to that product.
|
