Overview
In this article, we will cover how to calculate the predetermined overhead rate. The predetermined overhead rate is also commonly called predetermined absorption rate or predetermined overhead absorption rate. It also can be called as predetermined manufacturing overhead rate. Before jumping to detail, let’s go through the basic overview and key definition first.
When making pricing decisions about a product, the management of a business must first understand what the costs of the product are. If the management does not consider the cost of the product when setting its price, then the price of the product may end up being too unrealistic. For example, if a product costs $10 to make and the management of the business price the product $100, then it is highly likely that the business may not generate any sales due to the unrealistic price being charged on the product and end up making a loss on the production of the product. However, if the business sets the price of the same product as $1, without considering its cost, then the business will make huge losses on the product.
The costs of a product are easy to determine once the product has been produced. These costs generally include material costs, labor costs and overheads. However, for most businesses waiting until the product has been produced to determine its costs may not be an option. Therefore, these businesses may need to predict these costs beforehand. The material and labor costs are easy to predict as these can be calculated using estimated usage of material and labor per product multiplied with the expected rate of usage per unit of the product. However, the business may face problems when trying to determine the overhead cost per unit. To tackle this, the business must use a predetermined overhead rate.
Definition
A predetermined overhead rate is a rate that is assigned to specific products at the beginning of a period based on the estimated overheads for a specific period and estimated units to be produced. This allows a business to estimate its expected overheads costs per unit of a product, thus, allowing it to estimate the total per unit cost of a product by combining it with per unit material and labors cots of the product. The overheads used to calculate the predetermined overhead rate consists of only overheads associated with manufacturing the product.
To calculate the predetermined overhead rate of a product, a business must first estimate its level of activity or units to be produced. This can be estimated using several techniques such as break-even analysis and margin of safety or for more established businesses, this can be estimated using previous period’s or historical level of activity. Instead of using the numbers of units to be produced, the business may also choose another activity base such as labor hours or machine hours that are needed to meet the estimated level of activity.
Below are other bases of absorption in order to calculate the predetermined overhead rate a part from the units of production, direct labor hours and machine hours:
- As percentage of direct material costs
- As percentage of direct labor costs
- As percentage of prime costs
- As percentage of factory cost (for administrative overhead)
- As percentage of sales or factory cost (for selling and distribution overhead)
The choice of selecting any absorption basis depends on the judgment and common sense; especially depends on the type of the manufacturing activities. In addition, it also depends on the requirement which enable the calculation of predetermined overhead rate to realistically reflect the characteristics of a given cost center and which avoids undue anomalies.
The common activity bases include the direct labor hours and machine hours. Many factories or manufacturing companies prefer to use a direct labor hour rate or machine hour rate to other bases such as percentage of direct material cost, wages or prime cost as mentioned above. Below are some basic concept to consider to choose any bases for calculating the predetermined overhead rate:
(a) We commonly use direct labor hour as the basis when there is a labor intensive environment in a manufacturing company or factory.
(b) Alternatively, we use machine hour rate if in the factory or department of the production is mainly controlled or dictated by machines.
(c) Last but not least, we normally use a rate per unit to calculate the predetermined overhead rate when all units are identical.
Once the units to be produced or activity base has been estimated, the business must then estimate its total manufacturing costs based on the number of units to be produced. Once both these estimates have been made, the business can calculate its predetermined overhead rate.
Predetermined Overhead Rate Formula
It is important for businesses to understand how to calculate a predetermined overhead rate. This can easily be done by using the predetermined overhead formula. The predetermined overhead formula divides the total budgeted or estimated overheads of a business by the total expected units of production. This formula can be written as:
Predetermined Overhead Rate = Total Estimated Overheads / Total Estimated Units of Production
However, as mentioned above, some businesses may choose to use other basis for the predetermined overhead formula rather than the estimated units of production. The other basis used for predetermined overhead formula are direct labor costs, direct labor hours, machine hours, prime costs, etc. Therefore, the formula can also be written as:
Predetermined Overhead Rate = Total Estimated Overheads / Appropriate Activity Basis
Once the business understands how to calculate predetermined overhead rate, this rate can be applied to the price of products based on the actual level of activity during the accounting period. The formula to apply overheads to the activity is as below:
Applied Overhead = Predetermined Overhead Rate x Activity base Units
At the end of the accounting period, the total overheads absorbed based on the predetermined overhead rate are compared to the actual overheads incurred by the business. If the business absorbed more overheads than the actual overheads, then it is called over absorption and considered a profit for the business. If the business absorbs lower overheads as compared to actual overheads, then it is considered as under absorption and considered a loss for the business. In either case, the difference between absorbed overheads and actual overheads is adjusted in profits or losses of the business.
Example and Calculation
A company, ABC Co., wants to determine the costs of an upcoming job for pricing decisions. The company estimates for the material and labor costs of the job are as below:
| Description | # of unit |
|---|---|
| Material (2,000 units x $10 per unit) | $ 20,000 |
| Labor (350 labor hours x $50 per hour) | $ 17,500 |
The company also estimates that it will incur a total of $200,000 in overheads during the period. However, these overheads will be for the company as a whole and not for this specific job. Therefore, the company must use a predetermined overhead rate to limit how much overhead should be charged to this particular job. To do this, ABC Co. must first determine which basis it must use for the overhead allocation. The company estimates that it will have the following basis during the period:
| Description | # of unit |
|---|---|
| Total production in units | 40,000 units |
| Total direct labor hours | 8,050 hours |
Required:
Calculate predetermined overhead rate if ABC Co use either of the following basis:
- Total production in units
- Total direct labor hours
Solution:
- Total production in units basis:
If ABC Co. uses total production units as a basis, then the predetermined overhead for the job will calculated as follows:
Predetermined Overhead Rate = Total Estimated Overheads / Total Estimated Units of Production
= $200,000 / 40,000 units
= $5 per unit
Therefore, the total cost of the job will be calculated as follows:
| Description | Amount |
|---|---|
| Material (2,000 units x $10 per unit) | $ 20,000 |
| Labor (350 labor hours x $50 per hour) | $ 17,500 |
| Allocated overheads (2,000 units x $5 predetermined overhead rate) | $ 10,000 |
| Total cost | $ 47,500 |
- Total direct labor hours basis:
However, as mentioned above, some companies may choose to use direct labor hours as a basis instead of total units produced. If ABC Co. uses total labor hours basis, the predetermined overhead rate can be calculated using the following formula:
Predetermined Overhead Rate = Total Estimated Overheads / Total Labor Hours
= $200,000 / 8,000 hours
= $25 per hour
Therefore, the total cost of the job, using labor hours as an appropriate basis, will be calculated as follows:
| Description | Amount |
|---|---|
| Material (2,000 units x $10 per unit) | $ 20,000 |
| Labor (350 labor hours x $50 per hour) | $ 17,500 |
| Allocated overheads (350 hours x $25 predetermined overhead rate) | $ 8,750 |
| Total cost | $ 46,250 |
As is apparent from both calculations, using different basis will give different results. The price using units of production as a basis is $47,500 while the price using labor hours as a basis is $46,250. For some companies, the difference will be very minute or there will be no difference at all between different basis while for some other companies the differences will be significant. Therefore, a company should choose the basis for its predetermined overhead rates carefully after considering all the factors.
At the end of the job, ABC Co. had the following actual results:
| Description | Amount |
|---|---|
| Material (2,000 units x $10 per unit) | $ 20,000 |
| Labor (350 labor hours x $50 per hour) | $ 17,500 |
| Actual overheads | $ 9,500 |
| Total cost | $ 47,000 |
Now ABC Co. can compare its estimated results with actual results to evaluate how it has performed. The actual overheads incurred on the job are $9,500. If the company uses the units of production basis to calculate its predetermined overhead rate, then the company has made an overabsorption of $500 ($10,000 – $9,500) which is a profit for the business However, if the business uses the labor hours basis for calculating the rate, then the company has made an under absorption of $750 ($8,750 – $9,500) which is a loss for the company. However, whether ABC Co. made a profit or loss on the actual job can only be determined if the price of the job is known.
Why Do We Need to Calculate Predetermined Overhead Rate?
There are several reasons why businesses need to calculate a predetermined overhead rate. The most important reason is as mentioned above.
To Estimate the Total Manufacturing Costs
Businesses need to calculate a predetermined overhead rate to estimate the total manufacturing costs that are borne on the production of a single unit of a product. Based on this calculation, the business can make several decisions such as what the price of the product should be, how much resources should be allocated towards the production of the product, etc.
Enable Business to Calculate Profitability without Waiting for Actual Result
The predetermined overhead rate also allows businesses to easily calculate their profitability during the period without waiting for the actual results of its operations. This means that businesses can use the predetermined overhead rate to constantly evaluate its operations without having to wait for actual results to come in. This allows the business to proactively control its performance rather than taking a reactive approach towards it.
Allow Business to Use Consistent Costing Standards
Similarly, the predetermined overhead rate allows a business to use consistent costing standards with its products. In contrast, when actual overhead rates are calculated, they may have certain variations due to several reasons, such as inflation, seasonal variations, etc. that may produce inconsistent results in costing different products. For example, if a company incurs cooling expenses, then the expenses are likely to be higher in summer than in winter. This means that if an actual overhead rate is used by the business, the costs of products manufactured in summer will be higher than cost of goods manufactured in the winter. To tackle this problem predetermined overhead rates are used instead of actual overhead rates.
Can be Used in the Budgeting Process
Predetermined overhead rates are also used in the budgeting process of a business. Budgets are forecasts or plans for the future of a business. As discussed above, a business must wait until the end of a period to know the actual performance in terms of overheads incurred. However, since budgets are made at the start of the period, they do not allow the business to use actual results for planning or forecasting. Therefore, the business must use a predetermined overhead rate to budget its expenses for the future.
Since predetermined overhead rates are used in budgets, they can also act as a monitoring and controlling tool for businesses. When monitoring and controlling overheads, businesses need some standard, to compare actual overheads with, to understand whether the budget is being properly followed. In the absence of predetermined overhead rates, the business cannot compare actual expenses with any standard and, thus, cannot evaluate its actual performance.
What Are the Limitations of Predetermined Overhead Rates?
While predetermined overhead rates are widely used and needed for businesses, they may have some limitations. The first limitation is that they are based on estimates. A business needs to estimate its total overheads for a period and estimate its total units or activity basis for the predetermined overhead rates. If these estimates are not accurate, they can end up causing a lot of problems for the business specially if decisions are based on the rates, such as pricing decisions.
Similarly, as mentioned above some businesses may use it as a monitoring and control tool. If the predetermined overhead rates are not accurate, they can force the business to control its activities according to unrealistic rates. Furthermore, when actual costs are compared to the budgeted costs based on predetermined overhead rates, the variances may be too significant.
Finally, as discussed above, some businesses may calculate their predetermined overhead rates based on historical information. However, these estimates may produce inaccurate results in volatile businesses where historical information cannot be used as a basis to estimate future data.
Conclusion
Businesses need to calculate the costs of a product before the actual results can be determined due to several reasons. These costs include material, labor and overhead costs. While per unit material and labor costs can easily be estimated using simple calculations, to calculate the overhead costs for a single unit, a business must know how to calculate predetermined overhead rate. It is the estimated per unit costs of a product. These rates can be calculated using predetermine overhead formula by using estimated manufacturing overheads and estimated units of production or other valid basis. There are many reasons why businesses need to calculate predetermined overhead rates, although, they may have some limitations.
