The Concept of Predetermined Overhead Rate: Formula, and Example

Since both the numerator and denominator of the calculation are comprised of estimates, it is possible that the result will not bear much resemblance to the actual overhead rate. The following equation is used to calculate the predetermined overhead rate. Hire a professional to help you calculate your predetermined overhead rate. This option is best if you’re unsure of how to calculate your predetermined overhead rate or if you don’t have the time to do it yourself. You should calculate your predetermined overhead rate at least once per year. Again, this predetermined overhead rate can also be used to help the business owner estimate their margin on a product. Here’s how a service-based business, namely a marketing agency, might go about calculating its predetermined overhead rate.

The estimated total units in the allocation base is 1,000 direct labor hours. To calculate a predetermined overhead rate, divide the manufacturing overhead cost by the units of allocation. The overhead rate of cutting department is based on machine hours and that of finishing department on direct labor cost. The companies use different allocation bases when calculating their predetermined overhead rates. At the start of 2021, Dorothy’s Hat Company estimated that the total manufacturing overhead cost for the year would be $320,000, and the total machine hours would be 50,000 hours. Are all costs other than direct material, direct labor, or selling and administrative costs.

Example 2: eCommerce Business

Then, they’ll need to estimate the amount of activity or work that will be performed in that same time period. For this example, we’ll say the marketing agency estimates that it will work 2,500 hours in the upcoming year. Fixed costs are those that remain the same even when production or sales volume changes. So if your business is selling more products, you’ll still be paying the same amount in rent.

For the most accurate information, please ask your customer service representative. Clarify all fees and contract details before signing a contract or finalizing your purchase. Each individual’s unique needs should be considered when deciding on chosen products. This means that the overhead that is applied to jobs or products is different than the actual overhead from the product or job. Company X and Company Y are competing to acquire a massive order as that will make them much recognized in the market, and also, the project is lucrative for both of them.

Importance of Overhead

This rate is often used to speed up the closing of books, as it does not require the compilation of actual manufacturing overhead cost during the closing period. However, the problem with absorption/traditional predetermined overhead rate costing is that we have to ignore individual absorption bases and absorb all overheads using a single level of activity. Hence, this is a compromise on the accuracy of the overall allocation process.

Choose an activity that is used in the production of all types of output and which has a significant effect on total direct costs. For example, if the product or service is labor intensive, you could use direct labor costs or direct labor hours. Alternatively, if the factory is highly automated, machine hours would be a more appropriate basis. Companies that offer only one kind of service or produce a single type of product could use production volume as the basis of the calculation. To calculate the predetermined overhead, the company would determine what the allocation base is.

How to Calculate Predetermined Overhead Rate Machine Hours

You can calculate this rate by dividing the estimated manufacturing overhead costs for the period by the estimated number of units within the allocation base. The predetermined overhead rate was found by dividing the estimated manufacturing overhead cost by the estimated total units in the allocation base, so the predetermined overhead cost per unit is $9.00.

A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours. Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. The predetermined overhead rate is used to price new products and to calculate variances in overhead costs. Variances can be calculated for actual versus budgeted or forecasted results. Common examples of activity drivers are machine hours, direct materials, or direct labor hours.