Predetermined Overhead Rate POHR: Formula and Calculation

The formula for a predetermined overhead rate is expressed as a ratio of the estimated amount of manufacturing overhead to be incurred in a period to the estimated activity base for the period. The company, having calculated its overhead costs as $20 per labor hour, now has a baseline cost-per-hour figure that it can use to appropriately charge its customers for labor and earn https://www.bookstime.com/ a profit. That is, the company is now aware that a 5-hour job, for instance, will have an estimated overhead cost of $100. The predetermined overhead rate formula can be used to balance expenses with production costs and sales. For businesses in manufacturing, establishing and monitoring an overhead rate can help keep expenses proportional to production volumes and sales.

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The activity base (also known as the allocation base or activity driver) in the formula for predetermined overhead rate is often direct labor costs, direct labor hours, or machine hours. That is, a number of possible allocation bases such as direct labor hours, direct labor dollars, or machine hours can be used for the denominator of the predetermined overhead rate equation. The predetermined overhead rate is set at the beginning of the year and is calculated as the estimated (budgeted) overhead costs for the year divided by the estimated (budgeted) level of activity for the year. This activity base is often direct labor hours, direct labor costs, or machine hours. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost. As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2).

Estimate manufacturing overhead costs

• Once a company has determined the overhead, it must establish how to allocate the cost.
• If you have a large company, you may need to determine an allocation base for each department.
• This is calculated at the start of the accounting period and applied to production to facilitate determining a standard cost for a product.
• As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2).

Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour. Therefore, the predetermined overhead rate of TYC Ltd for the upcoming year is expected to be $320 per hour. The movie industry uses job order costing, and studios need to allocate overhead to each movie. Their amount of allocated overhead is not publicly known because while publications share how much money a movie has produced in ticket sales, it is rare that the actual expenses are released to the public. Small companies typically use activity-based costing, while large organizations will have departments that compute their own rates.

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As explained previously, the overhead is allocated to the individual jobs at the predetermined overhead rate of $2.50 per direct labor dollar when the jobs are complete. The formula calculates the predetermined overhead rate by dividing the estimated overhead costs for the period by the estimated activity level. This rate is then used to allocate overhead costs to products or projects based on the actual level of activity during the period. For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied.

They play a crucial role in assigning indirect costs to products or projects for the purpose of cost allocation, pricing decisions, and performance evaluation. Accurate calculation and application of the predetermined overhead rate help businesses manage costs effectively a predetermined overhead rate is calculated by dividing and make informed financial decisions. As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner. This allocation process depends on the use of a cost driver, which drives the production activity’s cost.

• Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process.
• To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis.
• To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too.
• The activity base (also known as the allocation base or activity driver) in the formula for predetermined overhead rate is often direct labor costs, direct labor hours, or machine hours.
• Based on the manufacturing process, it is also easy to determine the direct labor cost.
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Take, for instance, a manufacturing company that produces gadgets; the production process of the gadgets would require raw material inputs and direct labor. These two factors would definitely make up part of the cost of producing each gadget. Nonetheless, ignoring overhead costs, like utilities, rent, and administrative expenses that indirectly contribute to the production process of these gadgets, would result in underestimating the cost of each gadget.

The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The overhead is then applied to the cost of the product from the manufacturing overhead account. The overhead used in the allocation is an estimate due to the timing considerations already discussed. 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.

Advantages of predetermined overhead rate formula

You can calculate this rate by dividing the estimated manufacturing overhead costs for the period by the estimated number of units within the allocation base. A predetermined overhead rate, also known as a plant-wide overhead rate, is a calculation used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. The rate is determined by dividing the fixed overhead cost by the estimated number of direct labor hours. For example, assume a company expects its total manufacturing costs to amount to $400,000 in the coming period and the company expects the staff to work a total of 20,000 direct labor hours. In order to calculate the predetermined overhead rate for the coming period, the total manufacturing costs of $400,000 is divided by the estimated 20,000 direct labor hours. Traditionally, direct labor hours were used as the activity base, but technology continually decreases the amount of direct labor used in production, and machine hours or units produced have become more common activity bases.

• 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.
• Unexpected expenses can be a result of a big difference between actual and estimated overheads.
• The overhead is then applied to the cost of the product from the manufacturing overhead account.
• As explained previously, the overhead is allocated to the individual jobs at the predetermined overhead rate of $2.50 per direct labor dollar when the jobs are complete.
• Big businesses may actually use different predetermined overhead rates in different production departments, as these may vary significantly.

Predetermined Overhead Rate Formula