How to Calculate Predetermined Overhead Rate: Formula & Uses

The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too. While it may become more complex to have different rates for each department, it is still considered more accurate and helpful because the level of efficiency and precision increases.

• There are concerns that the rate may not be accurate, as it is based on estimates rather than actual data.
• The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed.
• The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved.
• A predetermined overhead rate(POHR) is the rate 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.
• Examples of overhead costs include rent, utilities, office supplies, and administrative salaries.

1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

Using the planned annual amounts for the upcoming year reduces the fluctuations that would occur if monthly rates were used. 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.

Relevance and Uses of Predetermined Overhead Rate Formula

This allocation process depends on the use of a cost driver, which drives the production activity’s cost. Examples can include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs. A predetermined overhead rate is an allocation rate given for indirect manufacturing costs that are involved in the production of a product (or several products). On your current project (coded as J-17), your division has spent $2,600 on direct materials; therefore, the predetermined overhead for this project will be $4,550 ($2,600 × 175%).

Problems with Predetermined Overhead Rates

When the predetermined overhead rate is not exactly what the company estimated, the rate would be either overapplied or underapplied. This is determined by applying the actual costs of manufacturing, once known, against the estimated manufacturing costs, and the difference will determine if the predetermined overhead rate was overapplied or underapplied. Prior to the start of the accounting year, JKL Corp calculates the predetermined annual overhead rate to be used in the new year. JKL’s profit plan for the new year includes $1,200,000 as the budgeted amount of manufacturing overhead.

• Examples can include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs.
• In order to find the overhead rate we will use the same basis that we have chosen by multiplying this basis by the calculated rate.
• The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period.
• As a result, management would likely view labor hours as the activity base when applying overhead costs.

Managers and accounting personnel should work together to analyze the historical overhead information to look for relationships between the total overhead and one of the specific allocation bases. A manager may notice that the overhead rate is usually about one and a half times the cost of direct labor for a given project. If this is consistent for many projects predetermined overhead rate in that department over the past year, then predetermined overhead for that department would be computed by multiplying the estimated cost for direct labor by 150%. A large number of overhead categories center around manufacturing, such as the expenses incurred to set up and maintain equipment, inspect products, clean factories, or keep records.

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• The overhead used in the allocation is an estimate due to the timing considerations already discussed.
• Using the formula, you divide the total overhead cost ($553,000) by the allocation base ($316,000) to get an allocation rate of 1.75 (175%).
• Overhead costs also include administrative salaries and some professional and miscellaneous fees that are tucked under selling, general, and administrative (SG&A) within a firm’s operating expenses on the income statement.
• The estimate is made at the beginning of an accounting period, before the commencement of any projects or specific jobs for which the rate is needed.
• The manufacturing overhead could be spread across all three accounts to be more accurate, but this is more time consuming.
• Another way to view it is overhead costs are those production costs that are not categorized as direct materials or direct labor.
• For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall.

That factory overhead needs to be allocated over all work-in-progress and finished goods during the period. Ahead of discussing how to calculate predetermined overhead rate, let’s define it. A predetermined overhead rate(POHR) is the rate used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. The predetermined overhead rate can be either overapplied or underapplied, depending on how accurate the company estimated the manufacturing overhead.

• Suppose that, over some period of time, the accrued wages for indirect labor, accumulated depreciation, accounts payable and utilities are equal to $500,000.
• To calculate the predetermined overhead, the company would determine what the allocation base is.
• Once a company has determined the overhead, it must establish how to allocate the cost.
• So the shoe manufacturer might spread overhead costs over 10,000 shoes rather than calculate each one separately.

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