Predetermined Overhead Rate: Key to Accurate Product Costing

The company’s budget shows an estimated manufacturing overhead cost of $16,000 for the forthcoming year. The company estimates that 4,000 direct labors hours will be worked in the forthcoming year. The predetermined overhead rate is a calculated metric used by businesses to estimate and allocate indirect costs before the actual costs are known. If estimated overhead differs significantly from actual overhead, there will be an overapplied or underapplied overhead. This difference is what is predetermined overhead rate usually adjusted at the end of the accounting period, often by allocating it to cost of goods sold. Knowing what is predetermined overhead rate helps in understanding variance analysis.

How accurate is the predetermined overhead rate?

• Determining this rate involves identifying various entities, including direct labor hours, overhead costs, unit production, and allocation method.
• It then computes the overhead rate, which is essential for businesses looking to control costs and maintain profitability.
• This calculation acts as a tool for timely reviews of spending, helping to trigger necessary adjustments in expense management in relation to changes in production or sales.
• As the production head wants to calculate the predetermined overhead rate, all the direct costs will be ignored, whether direct cost (labor or material).
• Using the predetermined overhead rate formula and calculation provides businesses with a percentage they can monitor on a quarterly, monthly, or even weekly basis.

Commonly, the manufacturing overhead cost for machine hours can be ascertained from the predetermined overhead rate in the manufacturing industry. Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals. A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period.

Direct Labor Hours

This forecast should be realistic and achievable, considering factors such as production capacity and anticipated demand. It then computes the overhead rate, which is essential for businesses looking to control costs and maintain profitability. Train your team, review assumptions each budget cycle, and reconcile applied vs. actual overhead. Done right, it gives you better cost visibility, smarter pricing, and stronger decision-making.

Steps in Using Predetermined Overhead Rates

• Overhead expenses are generally fixed costs, meaning they’re incurred whether or not a factory produces a single item or a retail store sells a single product.
• At the end of the accounting period, actual overhead costs are compared to the applied overhead.
• At the beginning of year 2021, the company estimated that its total manufacturing overhead cost would be $268,000 and the total direct labor cost would be 40,000 hours.
• It’s a simple method to use, but it may not reflect the variations in overhead costs incurred during different production periods.
• E-commerce businesses typically have different overhead structures – they might have higher technology and website maintenance costs but lower physical store expenses.
• Two companies, ABC company, and XYZ company are competing to get a massive order that will make them much recognized in the market.

A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability. The overhead rate is a cost added on to the direct costs of production in order to more accurately assess the profitability of each product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs. At the end of the accounting period, actual overhead costs are compared to the applied overhead. This reconciliation helps to identify any over- or under-application of overhead. So, for every machine hour you clock while manufacturing your furniture during the year, you would apply $25 of your estimated overhead costs to petty cash that product.

Selecting an Estimated Activity Base

Once you have a handle on your estimated overhead costs, you can plug these numbers into the formula. The most prominent Bookkeeping for Startups concern of this rate is that it is not realistic being that it is based on estimates. Since the numerator and denominator of the POHR formula are comprised of estimates, there is a possibility that the result will not be close to the actual overhead rate.

Breaking Down Overhead Costs: Fixed and Variable

• When making pricing decisions about a product, the management of a business must first understand what the costs of the product are.
• Before the beginning of any accounting year, it is determined to estimate the level of activity and the amount of overhead required to allocate the same.
• Analyzing historical data provides valuable insights into trends and patterns, enabling businesses to make informed decisions when establishing their predetermined overhead rates.
• However, if the business sets the price of the same product as $1, without considering its cost, then the business will make huge losses on the product.
• The total manufacturing overhead cost will be variable overhead, and fixed overhead, which is the sum of 145,000 + 420,000 equals 565,000 total manufacturing overhead.
• The activity driver, also known as the allocation base, is the factor used to assign overhead costs to products.

When companies begin the planning process of manufacturing a product, cost projections are a large and important focus. Calculating a predetermined overhead rate is one of the first tasks management will take on because it provides a formula to estimate the production costs of a product in advance. Specifically, the predetermined overhead rate is an approximated ratio of manufacturing overhead costs determined in advance based on variable and fixed costs.