Definition
A Predetermined Overhead Rate is a cost allocation method in finance, wherein a rate is established in advance for assigning overhead costs to cost objects, such as products or services, based on an estimated cost of the activity. This rate serves as a basis for predicting future overhead costs and is established before a period begins. It is typically calculated by dividing projected or estimated total overhead costs by a chosen allocation base such as estimated total units produced or labor hours.
Key Takeaways
- The Predetermined Overhead Rate is a method used in cost accounting to allocate indirect costs to production. It’s calculated before the accounting period and is essential for budgeting and setting price strategies.
- This rate is determined by dividing the estimated manufacturing overhead cost for a period by the estimated total units in the base for that same period. It helps in understanding how much overhead cost should be assigned to each unit of production.
- One of the main challenges with the Predetermined Overhead Rate is the accuracy of estimates. If the actual costs significantly differ from estimates, it could lead to under- or over-allocation of overheads. Therefore, consistent monitoring and adjustments are necessary.
Importance
The Predetermined Overhead Rate is an important financial term as it is used in cost accounting to allocate overhead costs to products or services.
It’s calculated at the beginning of a period, based on the estimated overhead costs and estimated activity levels, and is used throughout the period.
This rate is significant because it allows companies to accurately price their products or services by incorporating all the indirect costs associated with production.
By determining overhead rates in advance, companies can anticipate total costs, maintain consistency in their cost accounting procedures, and make informed financial and operational decisions.
Explanation
The Predetermined Overhead Rate plays a crucial role in cost accounting, serving as a method to allocate indirect costs, often referred as overheads, to activities, products or services. These overheads include costs that are not directly linked to production like rent, utilities, and salaries for employees in support roles.
The purpose of using a predetermined overhead rate is to estimate these costs in advance (typically before a production period commences), enabling businesses to accurately assess their production costs, determine pricing strategies, and calculate an approximation of potential profit margins. The Predetermined Overhead Rate is commonly used in product costing, budget preparation, and job costing – which involves assigning costs to specific production jobs or batches.
Given the difficulty of assigning indirect costs directly to individual products or jobs, having a standard, estimated rate ensures a fair and consistent distribution of these costs. It aids in the decision-making process by providing management with critical cost information, allowing them to make informed operational and strategic decisions on aspects such as pricing and project feasibility.
Thus, the Predetermined Overhead Rate enables greater overall financial control and higher managerial efficiency.
Examples of Predetermined Overhead Rate
Manufacturing Industry: In manufacturing companies, predetermined overhead rates are commonly used to allocate costs of indirect materials, indirect labor, and plant operational expenses (e.g., utilities, property insurance, property tax) to individual goods produced. Since these costs cannot be directly assigned to each product, management calculates a rate per machine hours or labor hours.
Hospitality Industry: Hotels and resorts may use predetermined overhead rates to distribute the overhead costs such as administrative salaries, resort maintenance, utilities, among various services such as rooms, food and beverages and event planning. Overhead rates could potentially be calculated based on various cost drivers like room days or meals served.
Healthcare Industry: Hospitals and healthcare facilities also make use of predetermined overhead rates to allocate costs of shared resources, such as utilities, administrative staff salaries, and maintenance, to different departments like Outpatient Care, Surgery, Pediatrics, etc. The rate can be calculated based on patient hours or the number of beds occupied in various departments.
Frequently Asked Questions about Predetermined Overhead Rate
What is a Predetermined Overhead Rate?
The Predetermined Overhead Rate is the rate used to apply manufacturing overhead to work-in-process inventory. It is calculated before a period begins. The formula to find the predetermined overhead rate is estimated manufacturing overhead cost divided by estimated total units in the allocation base.
What is the purpose of Predetermined Overhead Rate?
The purpose of the predetermined overhead rate is to allocate manufacturing overhead costs to individual jobs or batches of products, allowing businesses to cost products more accurately, make strategic pricing decisions, and monitor efficiency. It also helps in budgeting and minimizes the impact of seasonal fluctuation in overhead costs.
How is Predetermined Overhead Rate calculated in finance?
In finance, the Predetermined Overhead Rate is calculated by dividing the total estimated manufacturing overhead cost for the period by the estimated total amount of the allocation base. The allocation base is a measure such as direct labor hours or machine hours that is used to assign overhead costs to products and services.
What are some example uses of the Predetermined Overhead Rate?
The Predetermined Overhead Rate is widely used in cost accounting. A common application of this rate is in the computation of the cost of individual units of production in a manufacturing setting. This information can then be used to set selling prices, make capital investment decisions, create budgets, and control costs.
Related Entrepreneurship Terms
- Estimated Overhead Costs
- Direct Labor Hours
- Cost Driver
- Absorption Costing
- Activity-based Costing
Sources for More Information
- Investopedia: A comprehensive source of financial terms and definitions.
- Accounting Tools: Provides a vast array of accounting resources including explanations of various financial terms.
- My Accounting Course: A helpful resource with a large number of financial and accounting terms carefully explained.
- Corporate Finance Institute: Offers online courses and educational materials with detailed discussions on a multitude of finance topics.
