What is the predetermined overhead rate and why is it used?

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. It’s essential to fully understand the allocation base and allocation rate or variance for the predetermined overhead rate.

How To Calculate Predetermined Overhead Rate

The rate is configured by dividing the assumed overhead amount for a particular period by a certain activity base.

Predetermined Overhead Rate Formula = Estimated total manufacturing overhead cost / Estimated total units

Example

For example, an activity base that is common in calculating the predetermined overhead rate is labor costs. If the estimated manufacturing overhead costs for an accounting period are assumed to be $200,000 and the direct labor dollars is estimated at $150,000 the predetermined overhead rate would be 1.33. Therefore, every dollar of direct labor costs associated with production will cost $1.33 in total overhead costs.

Also see: Overhead costs explained

Operating Expenses Vs Overhead Expenses

To gain a better understanding of this concept, it is important to understand the differences between operating expenses and overhead expenses. In general, management teams will divide expenses between these two categories because they provide broader insight into an accurate product cost and the manufacturing of a product. As more and more products are produced, the greater the effect on profitability. Dividing expenses by operating and overhead help to set prices accordingly and increase profit margins. Manufacturing operating expenses typically are comprised of machines, direct materials cost, direct labor hours and actual machine hours needed to manufacture a product. The cost of some of these items can vary based on the job or number of units produced and may require job-order costing or activity-based costing.

Overhead expenses are items that are required to sell products and run the company in general. Examples of journal entries of overhead expenses are rent and utilities. The cost of these items is not dependent upon the total number of units produced by the company. In other words, a company’s rent will not change if they produce 1000 units in a reporting period or if they don’t produce any units.

Using a predetermined overhead rate is advantageous to company planners because it helps them form strategies for the future. Using this calculation gives the best possible estimation of costs based on relatively comfortable overhead estimations. If a business uses an actual overhead cost, they would not be able to determine true costs until after the production has actually happened.

Another tremendous advantage for companies using the predetermined overhead rate is it provides a more consistent analysis even during periods of season variability. Costs to heat and cool a building will vary depending on the time of year, and it is possible that materials costs can increase or decrease during the year depending on the type of product being produced. The predetermined overhead rate takes these variations into consideration and offers a more dependable estimated overhead total.

Most companies will adopt the use of predetermined overhead rates in order to know how their products are performing even before the accounting period ends. It is a way to constantly evaluate the profitability of manufacturing instead of waiting until that reporting period comes to an end.

Definition of Predetermined Overhead Rate

A predetermined overhead rate is often an annual rate used to assign or allocate indirect manufacturing costs to the goods it produces. Manufacturing overhead is allocated to products for various reasons including compliance with U.S. accounting principles and income tax regulations.

Traditionally, the predetermined manufacturing overhead rate was calculated prior to a new year by dividing the budgeted amount of manufacturing overhead for the upcoming year by the normal or expected number of production machine hours for the upcoming year. Using the planned annual amounts for the upcoming year reduces the fluctuations that would occur if monthly rates were used.

A manufacturer producing a variety of products that require different processes will have multiple overhead rates known as departmental overhead rates instead of just one plant-wide overhead rate.

Example of Predetermined Overhead Rate

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. JKL allocates the manufacturing overhead based on the normal and expected number of production machine hours which are 20,000 for the new year. Therefore, the JKL's predetermined manufacturing overhead rate for the new year will be $60 ($1,200,000/20,000) per production machine hour.