Using the Solo product as an example, 150,000 units are sold at a price of $20 per unit resulting in sales of $3,000,000. The cost of goods sold consists of direct materials of $3.50 per unit, direct labor of $10 per unit, and manufacturing overhead of $5.00 per unit. With 150,000 units, the direct material cost is $525,000; the direct labor cost is $1,500,000; and the manufacturing overhead applied is $750,000 for a total Cost of Goods Sold of $2,775,000.
The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. After reviewing the product cost and consulting with the marketing department, the sales prices were set. The sales price, cost of each product, and resulting gross profit are shown in Figure 6.6. To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too.
For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied. When the $700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is $5.00 per unit.
- As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs.
- This is related to an activity rate which is a similar calculation used in Activity-based costing.
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- Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner.
- 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.
Unexpected expenses can be a result of a big difference between actual and estimated overheads. From the above list, salaries of floor managers, factory rent, depreciation and property tax form part of manufacturing overhead. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year.
Relevance and Uses of Predetermined Overhead Rate Formula
While it may become more complex to have different rates for each department, it is still considered more accurate and helpful because the level of efficiency and precision increases. If you’d like to learn more about calculating rates, check out our in-depth interview with Madison Boehm. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.
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What is the right basis to use to calculate the overhead rate
Based on the manufacturing process, it is also easy to determine the direct labor cost. But determining the exact overhead costs is not easy, as the cost of electricity needed to dry, crush, and roast the nuts changes depending on the moisture content of the nuts upon arrival. However, one major disadvantage of the method is that both the numerator and the denominator are estimates and as such, it is possible that the actual result may vary significantly from the predetermined overhead rate. If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions. Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. Company B wants a predetermined rate for a new product that it will be launching soon.
Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead. A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost. This allocation can come in the form of the traditional overhead allocation method or activity-based costing..
What is a Predetermined Overhead Rate?
Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base. An activity base is considered to be a primary driver of overhead costs, and traditionally, direct labor hours or machine hours were used for it. For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be. As a result, management would likely view labor hours as the activity base when applying overhead costs. The controller of the Gertrude Radio Company wants to develop a predetermined overhead rate, which she can use to apply overhead more quickly in each reporting period, thereby allowing for a faster closing process. 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.
Calculate the predetermined overhead rate of GHJ Ltd if the required machine hours for next year’s production is estimated to be 10,000 hours. 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.
Further, the company uses direct labor hours to assign manufacturing overhead costs to products. As per the budget, the company will require 150,000 direct labor hours during the forthcoming year. A predetermined overhead rate, also known as a plant-wide overhead rate, is a calculation used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. The rate is determined by dividing the fixed overhead cost by the estimated number of direct labor hours. 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.
Overhead costs are then allocated to production according to the use of that activity, such as the number of machine setups needed. In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity. There are concerns that the rate may not be accurate, as it is based on estimates rather than actual data. In addition, changes in prices and industry trends can make historical data an unreliable predictor of future overhead costs. Finally, using a predetermined overhead rate can result in inaccurate decision-making if the rate is significantly different from the actual overhead cost.
The computation of the overhead cost per unit for all of the products is shown in Figure 6.4. The predetermined overhead rate is used to price new products and to calculate variances in overhead costs. This is related to an activity rate which is a similar calculation used in Activity-based costing. A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead. Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units. Any difference between applied overhead and the amount of overhead actually incurred is called over- or under-applied overhead.
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. As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2).