Predetermined Overhead Rate

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What is Predetermined Overhead Rate?

Predetermined overhead rate is an allocation rate that is used in manufacturing, applying an estimated manufacturing overhead to specific periods or jobs. Applying a predetermined overhead rate can be a valuable tool for manufacturers and is commonly used in business. Typically applied at the beginning of a reporting period, the rate can be used to keep track of a number of financial developments and help manufacturing accountants keep a close eye on the books.

A predetermined overhead rate is achieved by first estimating the total cost of the activity base, which is typically the total cost of labor hours, machine hours, and similar. Secondly, the total manufacturing overhead cost is estimated for the specific period of activity, order, or job. This figure is the sum of costs of the entirety of resources expended during the specific period. These resources are normally things like supply costs and utilities. The third and final step is to find what the predetermined overhead rate is. This is achieved by dividing the manufacturing overhead cost by the activity base. For example, if a manufacturing business estimates it has $12,000 in overhead costs and a $15,000 activity, the predetermined overhead rate is $0.80. This rate can now be deployed by the business to help them determine the estimated total cost of each job when completed.

Uses of Predetermined Overhead Rate

How to find a predetermined overhead rate is the first step, and there are a few options to apply it in practice. Now you know, as a business, how to calculate a predetermined overhead rate, you will want to know how and where to deploy it. In actual fact, the rate can be used in a number of areas quite flexibly and can be a hugely beneficial tool for businesses in financial planning.

  • Setting pricing: A predetermined overhead rate is used frequently by businesses looking to set prices. Since the rate gives the company a good idea of overhead costs per product or hour, it can be used to set a price that allows for good profitability.
  • Closing the books: The formula is also commonly used by businesses looking to close their books more rapidly. Deploying a predetermined overhead rate permits the business to close its books without having to compile actual overhead costs as part of the process. It is important to remember that the difference between estimated costs and actual costs must be reconciled before the end of the financial year.
  • Monitoring relative expenses: Using a predetermined overhead rate allows businesses to monitor relative expenses. Using the rate lets a business track this over a specific period, weekly, monthly, or quarterly. This helps a business see if costs are beginning to increase over a given period of time.
  • Monitoring overhead rate: A business may also compare the overhead rate with actual costs of a specific period of time. This allows businesses to track expenses of the period or job in question.

Concerns Surrounding Predetermined Overhead Rates

Applying a predetermined overhead rate can be a very useful tool for a business, but it can also be fraught with some risks. The first and most apparent is the fact that the predetermined overhead rate definition is inherently an estimate and may not be as accurate or as realistic as a business assumes. Both elements of the calculation are estimates, and it is possible that these estimates, and therefore the final rate itself, is significantly inaccurate. This will have a negative knock-on effect if decisions relating to sales and production are being taken on the basis of the predetermined overhead rate. The rate can also have shaky links to historical costs used to determine the manufacturing overhead. Sharp fluctuations in these historical costs, sudden increases or declines, may mean that these previously-used figures no longer apply. This means a predetermined overhead rate is a useful formula for planning and making decisions, but it should not be solely relied upon. Other factors should be considered when planning ahead for a specific period or job.

The Formula for Predetermined Overhead Rate

The predetermined overhead rate formula is itself is a relatively straightforward one. The predetermined overhead rate equals the estimated manufacturing cost overhead divided by the estimated activity base, sometimes known as the allocation base. This is the one simple formula you need to bear in mind when thinking: what is predetermined overhead rate?

Examples of Predetermined Overhead Rate

Let’s take a look at an example of a predetermined overhead rate. Let’s say that business X is unveiling a new product and wishes to calculate a relevant predetermined overhead rate. The business first ascertains how much overheads will be and the other costs incurred during production. This might be:

  • Direct labor (based on hours) $250,000
  • Direct material (based on units) $300,000
  • Variable overhead (based on labor hours) $150,000
  • Fixed overhead (based on labor hours) $400,000
  • Direct labor hours 10,000.
  • The estimated total manufacturing overhead costs would consist of variable and fixed overhead. The sum would be: 150,000 + 400,000 = 550,000.

The estimated total activity base would be the direct labor hours, in this case, 10,000. Therefore, the predetermined overhead rate can be calculated by the sum 550,000/10,000 giving a rate of $55. This rate can now be applied to the pricing of business X’s new product. Business X can set a price to ensure profitability on each unit, monitor its relative expenses and overhead rates, close the books on the job more rapidly. Business X should remember that all the previous caveats regarding estimates and the potential for sharply fluctuating costs still apply.

The predetermined overhead rate formula is a useful resource for businesses planning for the future. Larger businesses may even wish to calculate different rates for specific departments, which can encourage even higher levels of accuracy by employing even greater levels of precision across the business. However, it should not be forgotten that calculating the rate can potentially be a considerable task and is likely to add to the cost of required accounting labor itself. When numerous factors are taken into consideration, a predetermined overhead rate can be an instructive instrument for manufacturing businesses.

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