What is a predetermined overhead rate and how is it computed?
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If you have a company related to manufacturing, or you work as an accountant for such a business, it’s essential to calculate and monitor the predetermined overhead rate. This rate helps monitor expenses to produce goods or provide services while setting a reasonable price to earn profit. This rate also helps to determine when it’s time to review the company’s spending to protect its profit margins. Keep reading the article to learn more about the predetermined overhead rate and how to calculate and apply it. Understanding Predetermined Overhead RateIn accounting, a predetermined overhead rate is an allocation rate that applies a specific amount of manufacturing overhead to services or products. Typically, accountants estimate predetermined overhead at the beginning of each reporting period. Accountants calculate the rate by dividing the total estimated manufacturing overhead costs by an allocation base (also known as the activity driver). Here are some of the most commonly used activity drivers or allocation bases:
Typically, companies use this rate to close the books more quickly. The rate avoids collecting actual manufacturing overhead costs as part of the closing period. Note: an accountant must determine the difference between the estimated and actual amounts of overhead by the end of each fiscal year. It’s even recommended to calculate the difference more frequently. Now let’s dive into the details of the formula and calculation of this rate. Rate FormulaThe formula includes the following components:
Now let’s take a look at calculating the rate in detail. No More Bookkeeping Stress Keeping proper financial records is time-intensive and small mistakes can be costly. BooksTime makes sure your numbers are 100% accurate so you can focus on growing your business. How To Calculate Predetermined Overhead Rate?The predetermined overhead rate is determined by dividing the pre-calculated manufacturing overhead cost by the activity driver. Here’s an example: when the activity driver is machine-hours, then the accountant should divide overhead costs by the calculated number of machine-hours. Follow the short instruction to calculate overhead costs. Determine Estimated Manufacturing Overhead CostsManufacturing overhead costs are expenses related to overhead costs that result from producing products. Typically, manufacturing overhead costs include:
In some cases, the accountant could include employees’ salaries or wages in this list. Note: include employees’ salaries or wages only if these employees are directly involved in goods production. Here are a few examples:
Do not add office workers’ salaries. When you determine all company’s manufacturing overhead costs, add them to get the total. Determine The Estimated Activity Driver (Allocation Base)As mentioned in the article, accountants may use machine hours, direct labor hours or dollars, etc., as the allocation base. Suppose a business is focused on auto repair, then the accountant has to use direct labor hours in their calculation to determine how many hours it took for a mechanic to do their job. If a factory is producing some goods, the accountant should determine the number of hours a machine uses during the activity period. Determine Predetermined Overhead RateNow that all parts of the equation are determined let’s calculate the predetermined overhead rate. Divide the estimated manufacturing overhead costs by the activity driver. Let’s assume a company has $32,000 as manufacturing overhead costs and 7,000 as machine hours. In this case, the company’s predetermined overhead rate is $4.57 per unit. Predetermined Overhead Rate ExampleA company XYZ manufactures a product ABC. XYZ uses its labor hours to assign the manufacturing overhead cost. The accountant has calculated estimated manufacturing overhead expenses: $325,000. The estimated labor hours are 3,100 hours. The next step is to calculate a predetermined overhead rate: $325,000 / 3,100 = 104,8 So, the predetermined overhead rate is 104,8 per direct labor hour. Issues With Predetermined Overhead RatesAccounting differentiates several concerns related to using a predetermined overhead rate. To name a few:
Companies should be very careful when using the predetermined overhead rate to make decisions. It is recommended to use other mechanisms to make wise decisions. Use Cases Of Predetermined Overhead RateAs mentioned, the business could use this rate to close the books. But there are other use cases:
With the aid of this rate, companies may set prices on their products or services and ensure their expenses won’t go overboard. Share This ArticleRate the article Rate the article (1 voted) 5 / 5 Author: Charles Lutwidge What is a predetermined overhead rate and how is it calculated?A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base. The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product.
What is a predetermined rate overhead rate?What is Predetermined Overhead Rate? A predetermined overhead rate is an allocation rate that is used to apply an estimated cost of manufacturing overhead to either products or job orders.
What is the predetermined overhead rate and why is it used?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.
Which cost is calculated for predetermined rate?The formula for the predetermined overhead rate can be derived by using the following steps: Step 1: Firstly, determine the level of activity or the volume of production in the upcoming period. Step 2: Next, determine the estimated manufacturing overhead cost for that level of activity in the forthcoming period.
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