How To Calculate A Predetermined Overhead Rate

Calculating a predetermined overhead rate is a crucial aspect of cost accounting, allowing businesses to estimate and allocate overhead costs to products or services before the actual costs are incurred. This foresight helps in making informed pricing decisions, budgeting, and performance evaluations. Understanding the mechanics behind this calculation, along with its implications, provides a solid foundation for financial management.

Understanding Predetermined Overhead Rate

The predetermined overhead rate is the estimated rate at which overhead costs are applied to products or services. It's calculated at the beginning of an accounting period and is based on estimated overhead costs and an allocation base, such as direct labor hours, machine hours, or direct material costs. This rate is used throughout the period to apply overhead to work-in-process inventory.

Why Calculate a Predetermined Overhead Rate?

• Timely Costing: Actual overhead costs are often not known until the end of the accounting period. The predetermined rate allows businesses to apply overhead continuously, providing a more timely cost assessment for decision-making.
• Smoother Costing: Overhead costs can fluctuate due to seasonal factors or irregular expenses. Using a predetermined rate smooths out these fluctuations, leading to more consistent product costs.
• Pricing Decisions: Accurate product costs are vital for setting competitive prices. The predetermined overhead rate helps ensure that prices reflect all costs, including overhead.
• Budgeting and Planning: The estimated overhead costs used in the calculation contribute to the overall budget and provide a benchmark for controlling overhead spending.
• Performance Evaluation: By comparing actual overhead costs to the overhead applied using the predetermined rate, businesses can evaluate their performance in controlling overhead costs.

Steps to Calculate a Predetermined Overhead Rate

Calculating the predetermined overhead rate involves a straightforward process that consists of estimating overhead costs, selecting an allocation base, estimating the allocation base, and performing the calculation.

Step 1: Estimate Total Overhead Costs

The first step is to estimate the total overhead costs for the upcoming accounting period. Overhead costs are all indirect costs required to run a business, supporting the production of goods or provision of services. These costs cannot be directly traced to a specific product or service.

• Identify Overhead Costs: Begin by identifying all relevant overhead costs. Common examples include:
  • Indirect Labor: Wages of factory supervisors, maintenance staff, and other support personnel.
  • Indirect Materials: Materials used in the production process that are not a significant part of the final product, such as lubricants, cleaning supplies, and small tools.
  • Factory Rent: The cost of renting the factory or production facility.
  • Utilities: Electricity, gas, and water used in the factory.
  • Depreciation: Depreciation on factory equipment and buildings.
  • Factory Insurance: Insurance premiums for the factory.
  • Property Taxes: Taxes on factory property.
• Estimate Costs: For each overhead item, estimate the cost for the upcoming period. This can be based on historical data, expected changes in costs (e.g., utility rate increases), and production forecasts.
  • Historical Data: Review past overhead costs to identify trends and patterns.
  • Adjustments: Adjust historical costs to reflect expected changes. For example, if you anticipate a 5% increase in utility rates, increase the utility cost estimate accordingly.
  • Production Forecasts: Consider how changes in production volume might affect overhead costs. Some overhead costs, like indirect labor, may increase with higher production levels.
• Total Overhead Costs: Sum up all the estimated overhead costs to arrive at the total estimated overhead costs for the period.

Step 2: Select an Overhead Allocation Base

The overhead allocation base is a measure of activity that is used to assign overhead costs to products or services. The choice of allocation base should be driven by the activity that most directly causes overhead costs to be incurred.

• Common Allocation Bases:
  • Direct Labor Hours: The total number of hours worked by direct laborers. This is suitable when overhead costs are driven by labor-intensive processes.
  • Direct Labor Cost: The total cost of direct labor. This is another option for labor-intensive environments.
  • Machine Hours: The total number of hours that machines are used in production. This is appropriate when overhead costs are driven by machine-intensive processes.
  • Direct Material Cost: The total cost of direct materials used in production. This may be suitable when there is a strong correlation between material costs and overhead costs.
  • Units of Production: The number of units produced. This is often used when products are relatively homogeneous and overhead costs are consistent per unit.
• Criteria for Selecting an Allocation Base:
  • Causality: The allocation base should have a direct cause-and-effect relationship with overhead costs. In other words, changes in the allocation base should drive changes in overhead costs.
  • Availability of Information: The data for the allocation base should be readily available and easy to track.
  • Ease of Use: The allocation base should be easy to understand and apply.
• Example: If a company’s overhead costs are primarily driven by the use of machinery, machine hours would be an appropriate allocation base. If overhead costs are more closely related to labor, direct labor hours or direct labor cost would be better choices.

Step 3: Estimate the Total Amount of the Allocation Base

Once you have selected the allocation base, the next step is to estimate the total amount of that base for the upcoming accounting period.

• Direct Labor Hours: Estimate the total number of direct labor hours that will be worked during the period. This can be based on production schedules and historical data.
• Direct Labor Cost: Estimate the total cost of direct labor for the period. This involves estimating the number of direct labor hours and the average wage rate.
• Machine Hours: Estimate the total number of machine hours that will be used during the period. This can be based on production plans and machine capacity.
• Direct Material Cost: Estimate the total cost of direct materials that will be used during the period. This involves estimating the quantity of materials needed and their prices.
• Units of Production: Estimate the total number of units that will be produced during the period. This is based on sales forecasts and production capacity.

Step 4: Calculate the Predetermined Overhead Rate

With the estimated overhead costs and the estimated amount of the allocation base in hand, you can now calculate the predetermined overhead rate.

• Formula: Predetermined Overhead Rate = (Estimated Total Overhead Costs) / (Estimated Total Amount of the Allocation Base)
• Example:
  • Assume a company estimates its total overhead costs for the year to be $500,000 and plans to use 25,000 machine hours. The predetermined overhead rate would be: $500,000 / 25,000 = $20 per machine hour
• Interpretation: This means that for every machine hour used in production, $20 of overhead costs will be applied to the product.

Applying the Predetermined Overhead Rate

Once the predetermined overhead rate is calculated, it is used throughout the accounting period to apply overhead costs to work-in-process inventory. This involves multiplying the predetermined overhead rate by the actual amount of the allocation base used for each product or service.

Overhead Application

• Calculate Overhead Applied: Overhead Applied = Predetermined Overhead Rate x Actual Amount of the Allocation Base
• Example:
  • Using the predetermined overhead rate of $20 per machine hour, if a product requires 5 machine hours, the overhead applied to that product would be: $20 x 5 = $100
• Journal Entry: The application of overhead is recorded with a debit to Work-in-Process Inventory and a credit to Overhead Applied. This entry increases the value of the inventory and recognizes the overhead costs that have been allocated.

Over-Applied or Under-Applied Overhead

At the end of the accounting period, the overhead applied to work-in-process inventory is compared to the actual overhead costs incurred. This comparison reveals whether overhead was over-applied or under-applied.

• Over-Applied Overhead: Occurs when the overhead applied to products or services is greater than the actual overhead costs incurred. This means that the predetermined overhead rate was too high.
• Under-Applied Overhead: Occurs when the overhead applied to products or services is less than the actual overhead costs incurred. This means that the predetermined overhead rate was too low.

Disposition of Over-Applied or Under-Applied Overhead

When overhead is either over-applied or under-applied, it needs to be adjusted at the end of the accounting period. There are two main methods for disposing of over-applied or under-applied overhead:

• Cost of Goods Sold (COGS) Method: This method involves closing the over-applied or under-applied overhead directly to the Cost of Goods Sold account.
  • Over-Applied Overhead: If overhead is over-applied, COGS is decreased (credited) to reduce the overall cost of goods sold.
  • Under-Applied Overhead: If overhead is under-applied, COGS is increased (debited) to increase the overall cost of goods sold.
• Proration Method: This method involves allocating the over-applied or under-applied overhead among Work-in-Process Inventory, Finished Goods Inventory, and Cost of Goods Sold based on the proportion of overhead included in each account. This method is more accurate but also more complex.
  • Allocation: The over-applied or under-applied overhead is allocated based on the percentage of total overhead costs included in each account.
  • Adjustments: The inventory and COGS accounts are adjusted accordingly.

Factors Influencing the Predetermined Overhead Rate

Several factors can influence the accuracy and effectiveness of the predetermined overhead rate.

• Accuracy of Estimates: The accuracy of the estimated overhead costs and the estimated amount of the allocation base is critical. Inaccurate estimates can lead to significant over-application or under-application of overhead.
• Changes in Production Volume: Significant changes in production volume can affect overhead costs. If production volume is much higher or lower than expected, the predetermined overhead rate may not accurately reflect the actual costs.
• Changes in Overhead Costs: Unexpected changes in overhead costs, such as increases in utility rates or insurance premiums, can also affect the accuracy of the predetermined overhead rate.
• Choice of Allocation Base: The choice of allocation base can have a significant impact on the allocation of overhead costs. The allocation base should be closely related to the activities that drive overhead costs.
• Technology: Changes in production technology can affect both overhead costs and the allocation base. For example, the adoption of automated equipment may increase depreciation costs but decrease direct labor hours.

Advantages and Disadvantages of Using a Predetermined Overhead Rate

Using a predetermined overhead rate offers several advantages but also has some disadvantages.

Advantages

• Timely Costing: Allows for the application of overhead costs throughout the accounting period, providing a more timely assessment of product costs.
• Smoother Costing: Smooths out fluctuations in overhead costs, leading to more consistent product costs.
• Pricing Decisions: Supports informed pricing decisions by ensuring that prices reflect all costs, including overhead.
• Budgeting and Planning: Contributes to the overall budget and provides a benchmark for controlling overhead spending.
• Performance Evaluation: Allows for the comparison of actual overhead costs to the overhead applied, facilitating performance evaluation.

Disadvantages

• Reliance on Estimates: The accuracy of the predetermined overhead rate depends on the accuracy of the estimates, which can be challenging to predict.
• Potential for Over-Application or Under-Application: There is a risk of over-applying or under-applying overhead, which requires adjustment at the end of the accounting period.
• Simplification: The use of a single predetermined overhead rate may oversimplify the allocation of overhead costs, especially in complex manufacturing environments.
• Limited Accuracy: In situations where there are multiple products or services with different overhead requirements, a single rate may not accurately reflect the true costs.

Real-World Examples

To illustrate the application of the predetermined overhead rate, consider the following examples:

Example 1: Manufacturing Company

• Scenario: A manufacturing company estimates its total overhead costs for the year to be $800,000. It plans to use 40,000 direct labor hours.
• Calculation: Predetermined Overhead Rate = $800,000 / 40,000 = $20 per direct labor hour
• Application: If a product requires 2 direct labor hours, the overhead applied to that product would be: $20 x 2 = $40

Example 2: Service Company

• Scenario: A service company estimates its total overhead costs for the year to be $300,000. It plans to bill 15,000 professional hours.
• Calculation: Predetermined Overhead Rate = $300,000 / 15,000 = $20 per professional hour
• Application: If a service requires 10 professional hours, the overhead applied to that service would be: $20 x 10 = $200

Example 3: Machine-Intensive Production

• Scenario: A company estimates its total overhead costs to be $600,000 and its machine hours to be 30,000.
• Calculation: Predetermined Overhead Rate = $600,000 / 30,000 = $20 per machine hour
• Application: If a product uses 8 machine hours, the overhead applied to that product is: $20 x 8 = $160

Advanced Techniques

In complex environments, more advanced techniques may be used to improve the accuracy of overhead allocation.

Activity-Based Costing (ABC)

Activity-based costing (ABC) is a method of assigning overhead costs to products and services based on the activities that consume resources. ABC involves identifying activities, assigning costs to those activities, and then allocating costs to products based on their consumption of activities.

• Steps:
  • Identify Activities: Identify the activities that drive overhead costs, such as machine setup, material handling, and quality control.
  • Assign Costs to Activities: Assign costs to each activity based on the resources consumed.
  • Identify Cost Drivers: Identify the cost drivers for each activity, such as the number of setups, the number of material moves, and the number of inspections.
  • Calculate Activity Rates: Calculate the activity rate for each activity by dividing the total cost of the activity by the total amount of the cost driver.
  • Allocate Costs to Products: Allocate costs to products based on their consumption of activities.
• Benefits: ABC provides a more accurate allocation of overhead costs, especially in complex manufacturing environments with diverse products and services.

Multiple Overhead Rates

Instead of using a single predetermined overhead rate, some companies use multiple overhead rates for different departments or activities. This allows for a more precise allocation of overhead costs.

• Departmental Rates: Calculate separate overhead rates for each department based on the specific overhead costs and allocation base for that department.
• Activity-Specific Rates: Calculate separate overhead rates for different activities, such as machine setup, material handling, and quality control.
• Benefits: Using multiple overhead rates can improve the accuracy of overhead allocation, especially in situations where different departments or activities have significantly different overhead costs.

Best Practices

To ensure the effective use of the predetermined overhead rate, consider the following best practices:

• Accurate Estimates: Invest time and effort in developing accurate estimates of overhead costs and the allocation base.
• Regular Review: Regularly review and update the predetermined overhead rate to reflect changes in costs and production processes.
• Appropriate Allocation Base: Select an allocation base that has a strong cause-and-effect relationship with overhead costs.
• Transparency: Ensure that the calculation and application of the predetermined overhead rate are transparent and well-documented.
• Continuous Improvement: Continuously look for ways to improve the accuracy and effectiveness of the overhead allocation process.

Conclusion

Calculating and applying a predetermined overhead rate is an essential practice in cost accounting, enabling businesses to allocate overhead costs to products or services in a timely and consistent manner. By accurately estimating overhead costs, selecting an appropriate allocation base, and regularly reviewing the rate, companies can make informed pricing decisions, budget effectively, and evaluate performance. While challenges exist, the advantages of using a predetermined overhead rate—particularly in smoothing costs and providing timely information—make it an indispensable tool for financial management. Embracing advanced techniques such as activity-based costing and multiple overhead rates can further enhance the accuracy and relevance of overhead allocation, supporting better decision-making and improved profitability.