For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems. Using a plant-wide rate is logical when there is one root cause of the indirect production costs and the company manufactures similar products. When looking to calculate overhead rate and percentage, it’s important to sum up both of your company’s direct and indirect expenses.

Determining the overhead rate and percentage is a very important thing for all kinds of businesses. This allows the management of any business to initiate sensible operations.

## How is absorption costing treated under GAAP?

Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process. You can envision the potential problems in creating an overhead allocation rate within these circumstances.

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.

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 is the primary step to find out the overhead rate in any company no matter their size. In order to calculate the direct expenses, align the cost of direct labor and direct material that is required to manufacture the products or services that the company offers. For example, if a company sells mobile phones, the cost of materials and labor directly paid to the workforce and everything else that is involved in the manufacturing will be included in the direct expenses.

You would then take the measurement of what goes into production for the same period. So, if you were to measure the total direct labor cost for the week, the denominator would be the total weekly cost of direct labor for production that week. Finally, you would divide the indirect costs by the allocation measure to achieve how much in overhead costs for every dollar spent on direct labor for the week. Figure 4.18 shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl. As explained previously, the overhead is allocated to the individual jobs at the predetermined overhead rate of \$2.50 per direct labor dollar when the jobs are complete.

## Example 1: Costs in Dollars

The overhead rate allocates indirect costs to the direct costs tied to production by spreading or allocating the overhead costs based on the dollar amount for direct costs, total labor hours, or even machine hours. It is often difficult to assess precisely the amount of overhead costs that should be attributed to each production process. Costs must thus be estimated based on an overhead rate for each cost driver or activity. It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately.

• Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor.
• Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year.

It is advised for companies to review their overhead costs bi-monthly, monthly and on a quarterly basis by doing a regular bookkeeping. Calculating the overhead rate and percentage of a business essentially includes dividing the organization’s indirect expenses by direct expenses. As soon as a company figures out their overhead costs, it makes it easier for them to decide the prices for their products and services.

When thinking of direct expenses, think of the direct labor and material needed in the manufacturing of your product. In this case, if your company manufactured widgets, then your direct expenses would be the material needed in manufacturing and the labor costs for each and every production employee involved in making those widgets. An actual or budgeted overhead cost for a given period divided by the actual or budgeted measure of production activity (such as direct labor cost, labor hours, or machine hours).

This is necessary because it leads to a reduction in the prices of their products and services and allows them to stay competitive. The whole purpose of determining the overhead rate and percentage of expenses is eventually to decide the appropriate cost of products. In managerial accounting, rather than using one overhead rate to allocate all of the overhead costs, we can break up overhead costs by department. By using departmental overhead rates, we have the flexibility to use a different activity or cost driver for each department. Some departments rely heavily on manual labor but other departments rely heavily on machinery.

Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor.

The rate allows the company to keep track of the profit margin by contrasting the expenses with the cost. The rate also lets the company predict its profitability for the upcoming months and year. The company shall ideally have an overhead expense and cost that will significantly include a slight margin of the profit.

A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory. 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.

If a company prices its products that do not cover its overhead costs, the business will be unprofitable. So, if you wanted to determine the indirect costs for a week, you would total up your weekly indirect or overhead costs.

Direct expenses are directly proportional to the number of products manufactured each year. 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.