In order to make the widgets, the production process requires raw material inputs and direct labor. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output. So far, we haven’t used a singleactual overhead figure in our calculations.
Generally accepted accounting principles require businesses that use accrual basis accounting to include both direct and overhead expenses in production cost allocations. Predetermined overhead rates allow accounting employees to comply with the GAAP matching principal by allocating overhead while products are still in production. In business, overhead or overhead expense refers to an ongoing expense of operating a business. Overheads are the expenditure which cannot be conveniently traced to or identified with any particular cost unit, unlike operating expenses such as raw material and labor.
The predetermined overhead rate is the amount of manufacturing overhead that is estimated to be applied to each product or department depending on the cost system used (job order costing or process costing). It typically is estimated at the beginning of each period by dividing the estimated manufacturing overhead by an activity base. While it is most commonly a year, the period can be a year, quarter, or month as determined by management. In traditional allocation systems, that base is typically direct labor hours, direct labor dollars, or machine hours.
Therefore, overheads cannot be immediately associated with the products or services being offered, thus do not directly generate profits. However, overheads are still vital to business operations as they provide critical support for the business to carry out profit making activities.
One group is applying overhead based on the actual activity and the predetermined overhead rate. These accountants are adding direct materials, direct labor and applied overhead to jobs to calculate the cost of goods sold on every job that is sold. The second group of accountants is recording actual bills and totalling up actual overhead costs. Except these actual overhead costs are not included in cost of goods sold.
For example, overhead costs such as the rent for a factory allows workers to manufacture products which can then be sold for a profit. Overheads are also very important cost element along with direct materials and direct labor. Since the predetermined manufacturing overhead rate is an estimate, it is important to identify the actual overhead rate at the end of the reporting period.
How to Calculate Predetermined Overhead Rate Machine Hours
The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product. Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials.
] believe that such fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March.
- If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall.
- If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate.
The third step is to compute the predetermined overhead rate by dividing the estimated total manufacturing overhead costs by the estimated total amount of cost driver or activity base. Common activity bases used in the calculation include direct labor costs, direct labor hours, or machine hours. This activity base is often direct labor hours, direct labor costs, or machine hours.
The actual manufacturing overhead for the year was $123,900 and actual total direct labor was 21,000 hours. This results in $50,000 being allocated to inventory in the period. A later analysis reveals that the actual amount that should have been assigned to inventory is $48,000, so the $2,000 difference is charged to the cost of goods sold.
Accounting for Management
If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs.
The Formula for the Predetermined Overhead Rate
Actual overhead is the amount that the company actually incurred. Imagine that there are two groups of accountants inside a company.
In activity-based costing systems, the activity base is one or more cost drivers. Overhead costs are ongoing expenses a business incurs to operate. Many expenses are considered overhead costs, including rent, utilities, depreciation and labor. An overhead rate, or predetermined overhead rate, is an equation that allocates a certain amount of manufacturing overhead to each direct labor or machine hour.
How do you calculate a predetermined overhead rate?
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. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year.
Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost. is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base.
Calculation of Predetermined Overhead and Total Cost under Traditional Allocation
For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems. A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory. The pre-determined overhead rate is calculated before the period begins. The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period. The second step is to estimate the total manufacturing cost at that level of activity.
What is the predetermined overhead allocation rate?
The predetermined overhead rate for machine hours is calculated by dividing the estimated manufacturing overhead cost total by the estimated number of machine hours. This formula refers to the predetermined overhead because this overhead total is based on estimations, rather than the actual cost.