Calculating the predetermined overhead rate is a crucial step in cost accounting, allowing businesses to accurately allocate overhead costs to their products or services. This rate is essential for determining the full cost of production and setting appropriate selling prices. Understanding how to calculate this rate empowers businesses with the ability to make informed decisions, optimize pricing strategies, and enhance profitability.
The predetermined overhead rate is calculated by dividing the estimated total overhead costs for a specific period by the estimated activity base, which represents the level of production or output expected during that period. By utilizing this rate, businesses can distribute overhead costs consistently across their products or services, ensuring a fair and equitable allocation. This approach provides valuable insights into the true cost of each unit produced, enabling businesses to make informed pricing decisions that align with market demand and competitive dynamics.
Accurate calculation of the predetermined overhead rate is paramount for effective cost management and profitability analysis. By regularly reviewing and adjusting the rate based on actual overhead costs and production levels, businesses can ensure that their overhead costs are appropriately allocated and that their pricing strategies remain competitive. Additionally, this rate serves as a benchmark against which actual overhead costs can be compared, allowing businesses to identify areas for cost optimization and improve overall efficiency.
Definition of Predetermined Overhead Rate
A predetermined overhead rate (POHR) is a method of allocating overhead costs to products or services. It is calculated by dividing the estimated total overhead costs for a period by the estimated number of units that will be produced or sold during that period. The resulting rate is then used to apply overhead costs to each unit of production or sale.
POHRs are typically used in businesses that have a high volume of production or sales, and where the overhead costs are relatively stable. They can also be used in businesses that have a variety of products or services, each with different overhead costs.
There are a number of advantages to using POHRs. First, they can help businesses to more accurately estimate the cost of their products or services. This can lead to more informed decision-making about pricing and production levels.
Second, POHRs can help businesses to improve their efficiency. By knowing the overhead costs associated with each unit of production or sale, businesses can identify areas where costs can be reduced.
Third, POHRs can help businesses to better manage their cash flow. By knowing the total overhead costs for a period in advance, businesses can plan for the necessary cash flow to cover these costs.
Factors Influencing Overhead Rate Calculation
2. Activity Base Selection
The activity base chosen for overhead rate calculation plays a crucial role in its accuracy and relevance. It should be a reliable indicator of the level of activity that drives overhead costs. Common activity bases used in industries include:
Direct Labor Hours
- Measures the amount of time spent by direct labor on production activities.
- Suitable for companies with labor-intensive processes.
- Pros: Simple to collect and understand.
- Cons: May not be suitable for automated or outsourced production.
Machine Hours
- Measures the amount of time that machines are in operation.
- Appropriate for businesses with significant capital equipment.
- Pros: Provides insights into machine utilization and efficiency.
- Cons: Requires accurate records of machine usage.
Unit Production
- Measures the number of units produced.
- Ideal for companies with standardized, repetitive production processes.
- Pros: Easy to track and allocate overhead costs.
- Cons: Ignores variations in production complexity or resource consumption.
Sales Revenue
- Measures the amount of revenue generated from sales.
- Suitable for companies with diverse product offerings or services.
- Pros: Overhead costs can be distributed based on revenue contribution.
- Cons: May not reflect the actual drivers of overhead expenses.
3. Overhead Allocation Accuracy
The accuracy of overhead allocation depends on several factors, including:
- Cost Estimation: Overhead costs must be estimated accurately to ensure that the overhead rate is representative.
- Data Collection: Reliable data on the activity base and actual overhead costs is essential for precise rate calculation.
- Tracking System: A robust system should be in place to capture and track overhead expenses and activity data.
- Allocation Method: The allocation method used should be appropriate for the specific business and overhead cost drivers.
By carefully considering these factors, businesses can determine an overhead rate that provides a reasonable basis for allocating overhead costs and managing profitability.
Methods for Calculating Predetermined Overhead Rate
Traditional Method
The traditional method involves dividing the total estimated overhead costs by the total estimated activity base for a given period. This is a straightforward approach but can be less accurate if the overhead costs and activity levels do not have a consistent relationship or if the estimates are not reliable.
Activity-Based Costing (ABC) Method
The ABC method involves identifying and assigning overhead costs to specific activities that are required to produce goods or services. It then divides the total overhead costs for each activity by the corresponding activity volume to derive the predetermined overhead rate for that activity. The ABC method is more complex than the traditional method but can provide more accurate and granular overhead cost allocation.
Single Overhead Rate Method
The single overhead rate method is a simplified approach that uses a single predetermined overhead rate for all overhead costs. This is done by dividing the total estimated overhead costs by the total estimated direct labor hours or machine hours. The single overhead rate method is easy to apply but can be less accurate if the overhead costs vary significantly across different activities.
| Method | Formula |
|---|---|
| Traditional | Overhead Rate = Total Overhead Costs / Total Activity Base |
| ABC | Activity Overhead Rate = Total Overhead Costs for Activity / Total Activity Volume |
| Single Overhead Rate | Overhead Rate = Total Overhead Costs / Total Direct Labor Hours or Machine Hours |
Activity-Based Costing (ABC) Method
The Activity-Based Costing (ABC) method is a more detailed and accurate approach to calculating predetermined overhead rates. This method assigns overhead costs to products or services based on the specific activities that are performed to produce them. The ABC method involves the following steps:
1. Identify Activities
The first step is to identify the activities that are performed to produce the products or services. This can be done by observing the production process and interviewing employees. Activities can be classified into different categories, such as setup, production, inspection, and shipping.
2. Assign Costs to Activities
Once the activities have been identified, the next step is to assign costs to them. This can be done by using a variety of methods, such as direct tracing, engineering estimates, and statistical analysis.
3. Determine Activity Drivers
The next step is to determine the activity drivers for each activity. An activity driver is a measure of the amount of activity that occurs. For example, the activity driver for the setup activity might be the number of setups that are performed. The activity driver for the production activity might be the number of units that are produced.
4. Calculate Predetermined Overhead Rate
The predetermined overhead rate is calculated by dividing the total overhead costs by the total activity driver value. The resulting rate is then used to assign overhead costs to products or services based on the amount of activity that was required to produce them. The calculation is as follows:
| Predetermined Overhead Rate | = | Total Overhead Costs / Total Activity Driver Value |
|---|
Plant-Wide Rate Method
The plant-wide rate method allocates overhead costs to all production departments based on a single predetermined overhead rate. This rate is calculated by dividing the total estimated overhead costs for the period by the total estimated activity base for all production departments combined.
1. Estimated Overhead Costs
The first step is to estimate the total overhead costs for the period. These costs include all indirect costs that cannot be directly traced to specific products or services.
2. Activity Base
Next, determine the activity base that will be used to allocate overhead costs. The activity base should be a measure of the volume of activity that drives overhead costs.
3. Predetermined Overhead Rate
Once the estimated overhead costs and activity base have been determined, the predetermined overhead rate can be calculated using the following formula:
Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Activity Base
4. Overhead Cost Allocation
To allocate overhead costs to production departments, the predetermined overhead rate is multiplied by the actual activity level in each department.
5. Activity and Cost Bases
Various activity and cost bases can be used, including direct labor hours, machine hours, and production units. The choice of activity base depends on the nature of the overhead costs and the production process.
| Activity Base | Explanation |
|---|---|
| Direct Labor Hours | Measures the amount of labor required to produce goods or services. |
| Machine Hours | Measures the amount of time that machines are used in production. |
| Production Units | Measures the number of units produced. |
Department-Wide Rate Method
The department-wide rate method is a simple and straightforward method for calculating a predetermined overhead rate. This method allocates overhead costs to departments based on their total direct costs. The formula for calculating the department-wide overhead rate is:
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Department-Wide Rate = Total Overhead Costs / Total Direct Costs
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To use this method, you will need to gather the following information:
- Total overhead costs
- Total direct costs for each department
Once you have gathered this information, you can calculate the department-wide overhead rate for each department by dividing the total overhead costs by the total direct costs for that department.
Example
Let’s say that a company has the following overhead costs and direct costs for each department:
| Department | Overhead Costs | Direct Costs |
|---|---|---|
| Production | $100,000 | $500,000 |
| Marketing | $50,000 | $200,000 |
| Administration | $25,000 | $100,000 |
To calculate the department-wide overhead rate for each department, we would use the following formula:
“`
Department-Wide Rate = Total Overhead Costs / Total Direct Costs
“`
For the Production department:
“`
Department-Wide Rate = $100,000 / $500,000 = 0.20
“`
For the Marketing department:
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Department-Wide Rate = $50,000 / $200,000 = 0.25
“`
For the Administration department:
“`
Department-Wide Rate = $25,000 / $100,000 = 0.25
“`
This means that the Production department would apply a 20% overhead rate to its direct costs, the Marketing department would apply a 25% overhead rate to its direct costs, and the Administration department would apply a 25% overhead rate to its direct costs.
Multiple Overhead Rates
In some cases, it may be necessary to use multiple overhead rates for different departments or activities within a company. This can be done to ensure that each department or activity is charged an accurate amount for overhead costs. For example, a manufacturing company might use a separate overhead rate for its production and administrative departments. The production department would be charged an overhead rate that includes the costs of factory equipment, maintenance, and utilities. The administrative department would be charged an overhead rate that includes the costs of office equipment, supplies, and salaries.
To calculate multiple overhead rates, the company must first identify the different departments or activities that will be assigned separate rates. Once the departments or activities have been identified, the company must determine the total overhead costs that are associated with each department or activity. The total overhead costs can be determined by using historical data or by estimating the costs for the upcoming period.
Once the total overhead costs have been determined, the company must calculate the overhead rate for each department or activity. The overhead rate is calculated by dividing the total overhead costs by the total activity base. The activity base is the measure of activity that is used to allocate overhead costs. For example, the activity base for a production department might be the number of production hours. The activity base for an administrative department might be the number of employees.
The following table shows an example of how to calculate multiple overhead rates:
| Department | Total Overhead Costs | Activity Base | Overhead Rate |
|---|---|---|---|
| Production | $100,000 | 10,000 production hours | $10 per production hour |
| Administrative | $50,000 | 50 employees | $1,000 per employee |
Budgeting for Predetermined Overhead Rates
Budgeting plays a critical role in setting accurate predetermined overhead rates. Here are the steps involved in budgeting for overhead costs:
1. Identify Overhead Costs
List all overhead costs incurred during a production period, such as rent, utilities, depreciation, and administrative expenses.
2. Estimate Future Overhead Costs
Forecast future overhead costs based on historical data, industry trends, and expected changes in production volume.
3. Allocate Overhead Costs
Distribute overhead costs to different cost centers or activities based on appropriate allocation methods, such as direct labor hours or machine hours.
4. Calculate Overhead Rate
Determine the predetermined overhead rate by dividing the total estimated overhead costs by the estimated activity level. This rate is used to apply overhead costs to production.
5. Monitor and Adjust
Regularly monitor actual overhead costs and compare them to the budgeted amounts. Make adjustments to the overhead rate as needed to ensure accuracy.
6. Prior Periods
Consider overhead costs incurred in prior periods to identify trends and patterns that can inform budgeting for current and future periods.
7. Activity Level
Accurately estimate the activity level that will drive overhead costs. For example, direct labor hours or machine hours can be used as the measure of activity.
8. Evaluation and Refinement
Regularly evaluate the performance of the predetermined overhead rate against actual overhead costs and make necessary adjustments to improve accuracy and ensure reliable financial reporting. This ongoing evaluation and refinement process helps maintain the effectiveness of the predetermined overhead rate.
| Step | Description |
|---|---|
| 1 | Identify Overhead Costs |
| 2 | Estimate Future Overhead Costs |
| 3 | Allocate Overhead Costs |
| 4 | Calculate Overhead Rate |
| 5 | Monitor and Adjust |
| 6 | Prior Periods |
| 7 | Activity Level |
| 8 | Evaluation and Refinement |
Direct Labor Hours
Direct labor hours measure the amount of time workers spend performing tasks directly related to producing goods or services. It’s a straightforward and reliable method used by many companies. However, it may not accurately reflect overhead costs if direct labor hours are not a significant factor in the production process.
Machine Hours
Machine hours measure the amount of time machines are used in production. This method is suitable for businesses that rely heavily on machinery in their operations. It provides a more precise allocation of overhead costs based on machine usage.
Activity-Based Costing (ABC)
Activity-based costing (ABC) is a more complex but accurate method of assigning overhead costs based on the activities consumed in the production process. ABC identifies the activities that generate overhead costs, then allocates those costs to products or services based on the level of activity consumed.
Number of Units Produced
The number of units produced allocates overhead costs based on the number of units manufactured. It’s a simple method to use, but it may not reflect the variations in overhead costs incurred during different production periods.
Sales Revenue
Sales revenue measures overhead costs based on the revenue generated from selling the products or services. This method is used in industries where revenue is a significant indicator of resource consumption. It may not be suitable for companies with volatile sales patterns.
Percentage of Completion
For long-term contracts or projects, the percentage of completion method allocates overhead costs based on the project’s progress. It matches the overhead costs to the period in which the project is completed.
Fixed Overhead Cost
Fixed overhead costs remain constant regardless of the level of production. These costs are allocated evenly to products or services based on the chosen allocation base. It provides a more stable and predictable overhead rate.
Variable Overhead Cost
Variable overhead costs fluctuate with changes in the production volume. These costs are allocated based on the level of activity or resource consumption. It results in a more accurate representation of overhead costs for different production levels.
Mixed Overhead Cost
Mixed overhead costs have both fixed and variable components. To calculate a predetermined overhead rate for mixed costs, the fixed and variable portions must be separated. The fixed portion is allocated using a fixed allocation base, and the variable portion is assigned based on an activity measure.
Applications of Predetermined Overhead Rates
Predetermined overhead rates provide a valuable tool for various business applications, including:
1. Product Costing
Predetermined overhead rates are used to assign overhead costs to products or services, enabling accurate product costing and pricing.
2. Budgeting and Forecasting
These rates help businesses estimate future overhead costs and create realistic budgets and financial forecasts.
3. Decision-Making
By comparing actual overhead costs to predetermined rates, businesses can identify areas of inefficiency and make informed decisions for cost optimization.
4. Performance Measurement
Predetermined overhead rates serve as benchmarks for evaluating the efficiency of manufacturing processes and overhead control.
5. Transfer Pricing
When multiple departments or divisions within a company operate as separate profit centers, predetermined overhead rates facilitate the allocation of shared costs.
6. Inventory Valuation
Predetermined overhead rates are used to determine the value of inventory, ensuring accurate financial reporting.
7. Job Costing
For companies that bill customers based on specific jobs, predetermined overhead rates help determine the overhead portion of job costs.
8. Planning and Control
These rates aid in planning resource allocation and controlling overhead expenses, reducing cost overruns.
9. Break-Even Analysis
Predetermined overhead rates are crucial for break-even analysis, allowing businesses to determine the level of sales needed to cover fixed and variable costs.
10. Identifying Cost Drivers
Detailed analysis of predetermined overhead rates helps businesses identify the activities or factors that drive overhead costs, enabling targeted cost-reduction measures.
How to Calculate Predetermined Overhead Rate
A predetermined overhead rate (POHR) is a rate that is used to allocate overhead costs to products or services. It is calculated by dividing the total estimated overhead costs for a period by the total estimated activity for that period.
The most common types of activity used to calculate a POHR are direct labor hours, machine hours, and units produced. However, any activity that is a good measure of the consumption of overhead costs can be used.
Once the activity base has been determined, the following steps can be used to calculate the POHR:
- Estimate the total overhead costs for the period.
- Estimate the total activity for the period.
- Divide the total estimated overhead costs by the total estimated activity.
For example, if a company estimates that it will incur $100,000 in overhead costs and produce 100,000 units during a period, the POHR would be $1 per unit.
People Also Ask About How to Calculate Predetermined Overhead Rate
What is the purpose of a predetermined overhead rate?
A predetermined overhead rate is used to allocate overhead costs to products or services. This allows companies to track the true cost of production and set prices accordingly.
What are the different types of activity bases that can be used to calculate a POHR?
The most common types of activity bases are direct labor hours, machine hours, and units produced. However, any activity that is a good measure of the consumption of overhead costs can be used.
How often should a POHR be reviewed?
A POHR should be reviewed at least once a year. However, it may need to be reviewed more frequently if there are significant changes in the company’s operations.
