How Is Predetermined Overhead Rate Calculated

Calculate your company’s predetermined overhead rate quickly and accurately. This rate is crucial for estimating product costs and setting prices.

Formula: Estimated Overhead Cost / Estimated Allocation Base

Comparison of Estimated vs. Applied Overhead

Example of Overhead Application to Jobs/Products

Job/Product	Allocation Base Used	Predetermined Rate	Overhead Applied
Job 101	150 hours	$0.00 per hour	$0.00
Product A	80 hours	$0.00 per hour	$0.00

What is the Predetermined Overhead Rate?

The Predetermined Overhead Rate is an estimate used by companies to allocate their estimated manufacturing overhead costs to products or jobs over a specific period. It is calculated at the beginning of an accounting period before the actual costs and activity levels are known. The primary purpose of using a Predetermined Overhead Rate is to provide a way to assign overhead costs to products in a timely manner, rather than waiting until the end of the period when actual costs are finalized. This allows for more timely product costing, pricing decisions, and inventory valuation.

Businesses, especially those in manufacturing or that perform job-order costing, use the Predetermined Overhead Rate to determine the cost of their goods or services. It helps smooth out the fluctuations in overhead costs and activity levels that can occur throughout the year.

A common misconception is that the Predetermined Overhead Rate is the actual overhead cost. It’s an estimate, and any difference between the total overhead applied using the predetermined rate and the actual overhead incurred during the period results in either underapplied or overapplied overhead, which is typically adjusted at the end of the period.

Predetermined Overhead Rate Formula and Mathematical Explanation

The formula for calculating the Predetermined Overhead Rate is:

Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Amount of Allocation Base

Here’s a step-by-step breakdown:

1. Estimate Total Manufacturing Overhead Costs: Sum up all indirect manufacturing costs expected for the upcoming period (e.g., indirect materials, indirect labor, factory rent, utilities, depreciation on factory equipment).
2. Choose an Allocation Base: Select a measure of activity that drives overhead costs. Common bases include direct labor hours, machine hours, direct labor cost, or units of production. The choice depends on which base has the strongest relationship with the overhead costs being incurred.
3. Estimate the Total Amount of the Allocation Base: Estimate the total quantity of the chosen allocation base expected for the period (e.g., total direct labor hours to be worked).
4. Calculate the Rate: Divide the estimated overhead costs by the estimated allocation base amount.

The resulting rate is expressed in terms of the allocation base (e.g., dollars per direct labor hour, dollars per machine hour, or as a percentage of direct labor cost).

Variables in the Predetermined Overhead Rate Calculation

Variable	Meaning	Unit	Typical Range
Estimated Total Manufacturing Overhead Costs	The sum of all expected indirect factory costs.	Currency ($)	$10,000 – $10,000,000+
Estimated Total Allocation Base	The total expected quantity of the base used to allocate overhead.	Hours, Currency ($), Units	100 – 1,000,000+
Predetermined Overhead Rate	The rate used to apply overhead to products or jobs.	$/hour, $/unit, %	$1 – $500/hour, 10% – 500%

Practical Examples (Real-World Use Cases)

Example 1: Using Direct Labor Hours

XYZ Furniture estimates its total manufacturing overhead for the year to be $600,000. They expect their workers to log 30,000 direct labor hours. They use direct labor hours as their allocation base.

Predetermined Overhead Rate = $600,000 / 30,000 direct labor hours = $20 per direct labor hour.

If a particular furniture piece (Job 105) takes 5 direct labor hours, the overhead applied to Job 105 would be 5 hours * $20/hour = $100.

Example 2: Using Machine Hours

ABC Machining estimates its total manufacturing overhead to be $1,200,000 for the upcoming year. The company is heavily automated and decides machine hours are the best allocation base, estimating 60,000 machine hours.

Predetermined Overhead Rate = $1,200,000 / 60,000 machine hours = $20 per machine hour.

If a product (Product B) requires 3 machine hours to produce, the overhead applied would be 3 hours * $20/hour = $60 per unit of Product B.

Understanding the Predetermined Overhead Rate is vital for job costing and accurate product pricing.

How to Use This Predetermined Overhead Rate Calculator

1. Enter Estimated Overhead: Input the total estimated manufacturing overhead costs for the period in the first field.
2. Select Allocation Base Type: Choose the allocation base (Direct Labor Hours, Machine Hours, or Direct Labor Cost) from the dropdown menu that best reflects what drives your overhead costs. The unit for the next field will update automatically.
3. Enter Estimated Allocation Base Amount: Input the total estimated amount for your chosen allocation base (e.g., total expected direct labor hours).
4. Enter Actual Allocation Base (for Chart): Optionally, enter an actual or hypothetical amount of the allocation base used to see a comparison of estimated and applied overhead in the chart.
5. View Results: The calculator will instantly display the Predetermined Overhead Rate, total overhead, total allocation base, and applied overhead based on the actual base entered. The rate will be shown per unit of your chosen allocation base.
6. Use the Rate: Apply the calculated rate to the actual amount of allocation base used by each job or product to assign overhead costs.
7. Analyze Chart and Table: The chart visually compares estimated overhead with overhead applied based on your ‘Actual Allocation Base’ input. The table shows examples of applying the calculated rate.

The resulting Predetermined Overhead Rate is crucial for setting selling prices, valuing inventory, and making informed business decisions.

Key Factors That Affect Predetermined Overhead Rate Results

• Accuracy of Overhead Cost Estimates: If the initial estimate of total overhead costs is significantly different from actual costs, the rate will be inaccurate, leading to under or overapplied overhead.
• Accuracy of Allocation Base Estimates: Similarly, an inaccurate estimate of the total allocation base (e.g., direct labor hours) will skew the Predetermined Overhead Rate.
• Choice of Allocation Base: Selecting an allocation base that doesn’t truly drive overhead costs can lead to distorted product costs. For example, using direct labor hours in a highly automated department where machine hours drive costs would be inappropriate. Consider activity-based costing for more accuracy.
• Changes in Production Volume: If actual production volume differs greatly from the estimated volume used to determine the allocation base, the rate’s effectiveness diminishes.
• Changes in Cost Structure: A shift in the mix of fixed and variable overhead costs, or significant unexpected expenses, can make the initial estimates less reliable.
• Seasonality or Business Cycles: Fluctuations in activity due to seasonal demand or economic cycles can impact the actual allocation base compared to the estimate, affecting the Predetermined Overhead Rate‘s application. Proper budgeting can help anticipate some of these.
• Technological Changes: Automation can reduce direct labor and increase machine-related overhead, potentially requiring a change in the allocation base and recalculation of the Predetermined Overhead Rate.

Frequently Asked Questions (FAQ)

What is the purpose of using a Predetermined Overhead Rate?

It allows businesses to estimate and apply overhead costs to products or jobs throughout an accounting period, rather than waiting until the end when actual costs are known. This facilitates timely costing, pricing, and inventory valuation.

Why not use actual overhead rates?

Actual overhead costs and activity levels are often not known until the end of a period. Waiting would delay product costing. Also, actual rates can fluctuate significantly month-to-month due to variations in costs and activity, while a Predetermined Overhead Rate smooths these out.

What is underapplied or overapplied overhead?

Underapplied overhead occurs when the overhead applied to production (using the Predetermined Overhead Rate) is less than the actual overhead incurred. Overapplied overhead is when the applied overhead exceeds actual overhead. These differences are usually adjusted at the end of the period, often to the Cost of Goods Sold.

How often should the Predetermined Overhead Rate be calculated?

Typically, it’s calculated at the beginning of each fiscal year. However, if there are significant changes in estimated costs or activity levels during the year, it may need to be revised.

What are the most common allocation bases?

Direct labor hours, machine hours, and direct labor cost are very common. The best base is the one that has the strongest cause-and-effect relationship with the incurrence of overhead costs.

Can a company have more than one Predetermined Overhead Rate?

Yes, many companies use multiple rates, especially if they have different departments or production processes with different cost drivers. For example, one rate for a labor-intensive department and another for a machine-intensive department. This is a step towards activity-based costing.

What’s the difference between manufacturing overhead and other overhead?

Manufacturing overhead relates directly to the production process (indirect materials, indirect labor, factory utilities). Other overhead (selling, general, and administrative expenses) is not included in the Predetermined Overhead Rate for product costing but is expensed in the period incurred.

How does the Predetermined Overhead Rate relate to product costing?

It’s a key component in calculating the total cost of a product, along with direct materials and direct labor. The overhead applied using the rate is added to these direct costs to get the total product cost, influencing product costing methods.