Costing is an essential part of any business. Whether it is products or services, companies must calculate the cost of their items. Once they can do so reliably, companies can use the information in various decisions. However, determining the actual product or service cost can be complex. Usually, assigning direct costs to a product or unit is straightforward. The same does not apply to indirect costs.
Although not directly related to a specific product or service, indirect costs are still paramount in decision-making. However, companies make most decisions before producing an item before the actual costs happen. It is crucial to estimate and allocate them to a specific unit. Consequently, companies must calculate the predetermined overhead rate.
What is the Predetermined Overhead Rate?
The predetermined overhead rate is a per-unit allocation rate used to assign indirect costs. It uses the total estimated overhead costs for a period and divides them by the expected production units. Consequently, it provides rates companies can apply to every product or service produced. The predetermined rate is crucial in assigning total costs to products during the manufacturing process.
The predetermined overhead rate estimates the costs a company incurs during a period. The primary reason is that companies need to assign this rate to various products. Therefore, waiting for the actual costs and using the information to derive an accurate cost is not an option. Companies also use an activity base to assign this cost to products, usually the number of units produced.
How to calculate the Predetermined Overhead Rate?
Calculating the predetermined overhead rate is straightforward. As stated above, it involves calculating the total manufacturing overhead cost and dividing it by an activity base. Based on this definition, the formula for the predetermined overhead rate is below.
Predetermined overhead rate = Estimated manufacturing overhead costs / Expected number of units to be produced
The above predetermined overhead rate formula uses the number of units as an activity base. Sometimes, it may differ based on a company’s needs and manufacturing process. Nonetheless, the essence of the formula for the predetermined overhead rate will remain the same. Other bases that companies may use to determine this rate include the following:
- Labor hours
- Machine hours
- Number of employees
- Number of service calls
- Kilowatt-hours used
- Square footage
Example
Blue Co. estimates its manufacturing costs for a period to be $100,000. The company expects to produce 2,000 units of its products during that period. Consequently, Blue Co. calculates the predetermined overhead rate as follows.
Predetermined overhead rate = Estimated manufacturing overhead costs / Expected number of units to be produced
Predetermined overhead rate = $100,000 / 2,000 units
Predetermined overhead rate = $50 per unit
The predetermined overhead rate means Blue Co. will apply a $50 cost to every unit produced during the period. The actual expenses may differ from the ones estimated by this rate. However, that does not impact how Blue Co. uses the predetermined rate. Instead, it requires an accounting adjustment later.
Conclusion
A predetermined overhead rate is an estimated per-unit cost based on an activity base. Companies apply this cost to every product or service unit the company produces during a specific period. However, it differs from direct costs, which are directly attributable to a single item. The predetermined overhead rate may vary from the actual manufacturing overhead per unit for each product.
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