How to Find Predetermined Overhead Rate
Before companies launch a new product or service, they often need to find the predetermined overhead rate for that particular good or service. Finding the predetermined overhead rate is necessary in order to keep expenses in tandem with both production levels and expected sales. This ensures that businesses price their products and services using the right type of pricing strategy to earn a profit. It also aids companies to monitor their expenses and review them when necessary to continue being profitable. In this article, we shall discuss how to find predetermined overhead rate.
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What is predetermined overhead rate?
Manufacturers usually use the predetermined overhead rate in comparison to the actual cost of production to monitor expenses and ensure that costs are not escalating above the desired threshold such that it affects their bottom line. It also aids in setting accurate prices that account for the cost of production while maintaining profitability.
The predetermined overhead rate also aids companies in closing their financial books more quickly as it allows them to avoid compiling actual overhead costs as part of their closing process. However, reconciling the difference between the estimated overhead rate and the actual overhead rate is still important, hence, companies should ensure this is done at the end of each quarter or each fiscal year.
What is the formula for predetermined overhead rate?
The estimated manufacturing overhead cost of a company includes all overhead costs associated with the manufacturing process excluding the selling cost, direct labor, administrative cost, or direct materials. Instead, it includes rent, facility maintenance, utilities, factory supplies, and depreciation of equipment. The facility maintenance usually includes all monies spent on keeping the manufacturing facility operational such as janitorial costs or the cost of repairs. Utilities include waste disposal, electricity, and water supply.
The allocation base is a cost accounting descriptor based on the common activity that affects overhead cost. It usually includes costs directly associated with manufacturing or the main activity driver such as the cost of direct labor, hours of machine operation, direct material, or direct labor hours.
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How to find predetermined overhead rate
Calculate the estimated manufacturing overhead cost
Determine the estimated allocation base
Calculate the predetermined overhead rate
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Predetermined overhead rate examples and calculations
Example 1
Assuming Mr. Reginald owns a bicycle production company and has budgeted the following as cost for the year:
| Item | Value |
|---|---|
| Direct labor hours | 150,000 |
| Direct labor cost | $80,000,000 |
| Property tax | $4,000,000 |
| Supervisor salaries | $40,000,000 |
| Cost of raw materials | $150,000,000 |
| Factory rent | $10,000,000 |
| Depreciation | $6,000,000 |
In order to calculate the predetermined overhead rate we will use the formula, Predetermined overhead cost = Estimated manufacturing overhead cost ÷ Estimated units of the allocation base for the period
Estimated manufacturing overhead cost = Property tax + Supervisor salaries + Factory rent + Depreciation = $4,000,000 + $40,000,000 + $10,000,000 + $6,000,000 = $60,000,000
Estimated units of the allocation base for the period = Direct labor hours = 150,000
Predetermined overhead cost = $60,000,000 ÷ 150,000
Predetermined overhead cost = $400 per hour
This means that the predetermined overhead rate for Mr. Rginald’s bicycle production company is $400 per hour for the year.
Example 2
Miss. Grey is the head of an automobile production company and the company wants to produce a new line of automobiles. In order to ensure that the price of the new automobile is not too high or too low, she has directed the head of production to develop the details of costing based on the overhead cost of their already existing automobiles. After making necessary inquiries and adjustments based on the specifications of the new automobile, the following production cost details were given to Miss. Grey:
| Particular | Units | Amount |
|---|---|---|
| Direct labor hours | 3,000 | |
| Direct machine hours | 10,000 | |
| Direct labor | Based on labor hours | $28,000,000 |
| Direct material | Based on number of units | $40,000,000 |
| Fixed overhead | Based on labor hours | $500,000,000 |
| Variable overhead | Based on labor hours | $189,000,000 |
To calculate the predetermined overhead rate, we will take into account the variable and fixed cost, as well as the direct machine hours since the allocation base we are using, is the machine hours.
The formula we will use is Predetermined overhead rate = Estimated manufacturing overhead cost ÷ Estimated units of the allocation base for the period
Estimated manufacturing overhead cost = Fixed overhead + Variable overhead = $500,000,000 + $189,000,000 = $689,000,000
Estimated units of the allocation base for the period = 10,000
Predetermined overhead rate = 689,000,000 ÷ 10,000
Predetermined overhead rate = $68,900 per hour
This implies that the predetermined overhead rate for the new automobiles based on machine hours is $68,900 per hour
Example 3
Suppose a cable Tv manufacturing company uses its labor hours to assign the manufacturing overhead cost. If the estimated manufacturing overhead cost is $265,000 and the estimated labor hours are 3,000 hours. We can calculate the predetermined overhead rate as follows:
Predetermined overhead rate = Estimated manufacturing overhead cost ÷ Estimated units of the allocation base for the period
Predetermined overhead rate = $265,000 ÷ 3,000
Predetermined overhead rate = $88.33 per labor hour
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Conclusion
Finding the predetermined overhead rate is very important for manufacturers as it provides a hint on the overhead of production thereby aiding businesses in understanding and managing costs. It also aids in cost allocation when it comes to budgeting. It also guides the accurate pricing of products to ensure that products are not overpriced or underpriced so as to make optimum profit from products.
Furthermore, the simple steps we have discussed above on how to find the predetermined overhead rate can be easily applied by amateur entrepreneurs, accountants, or seasoned business owners when they want to calculate the predetermined overhead cost of any of their products.
