Definition
The Predetermined Overhead Rate Formula is a finance and accounting term that is used to allocate estimated manufacturing overhead costs to products or jobs. It’s formulated by dividing estimated overhead costs by some measure of estimated total output such as direct labor-hours or machine-hours. This rate is typically established before a period begins and helps companies to estimate costs more accurately.
Key Takeaways
- The Predetermined Overhead Rate Formula is used to allocate indirect costs to the production of goods or services. This usually includes costs of indirect materials, indirect labor, rent, utilities etc that are not directly linked with the production.
- Predetermined Overhead Rate is calculated by dividing estimated total overhead costs for a period by the estimated total amount of cost driver or activity base. The formula is commonly defined as Estimated Overhead Cost/Estimated Activity Base.
- Applying Predetermined Overhead Rate helps in achieving more accurate costing and pricing decisions. Yet, it’s crucial to remember that it’s based on estimates and should be reviewed periodically to make sure it accurately reflects the company’s actual overhead costs and production volume.
Importance
The Predetermined Overhead Rate Formula is significant in financial management as it helps businesses predict their overhead costs before a specific period starts.
This formula facilitates accurate budgeting and cost control, allowing organizations to appropriately allocate their overhead costs to different departments, products, or jobs.
Accurate overhead allocation is crucial because it affects product pricing, profitability analysis, and decision-making processes within a business.
Furthermore, by using this formula, companies can better anticipate unexpected increases in costs and promptly mitigate the potential monetary issues.
Thus, the Predetermined Overhead Rate Formula plays a fundamental role in financial planning and management.
Explanation
The predetermined overhead rate formula is a critical tool in managerial accounting for determining how much indirect cost a company allocates to its products or services. The primary objective is to accurately determine the cost of producing goods or services by allocating overhead costs based on a particular cost driver.
These overhead costs might include depreciation, indirect labor, rent, utilities, etc. By accurately identifying these costs, businesses can ensure they are pricing their products or services correctly and are maintaining an accurate picture of profitability.
Moreover, the predetermined overhead rate formula is particularly used in situations where the company’s overhead costs are not directly proportional to the direct costs or when they fluctuate frequently. It enables the company to project their indirect costs more accurately, making the budgeting process more efficient.
Pricing decisions, product line decisions, financial forecasting, and cost control are all crucial strategic areas where the predetermined overhead rate becomes an indispensable asset.
Examples of Predetermined Overhead Rate Formula
The Predetermined Overhead Rate Formula is widely used across different industries for cost allocation. Here are three real-world examples:
Manufacturing Industry: A factory that produces furniture uses the predetermined overhead rate to allocate overhead costs to each piece of furniture produced. For instance, if the estimated overhead costs for a year are $100,000 and direct labor hours are expected to be 10,000 hours, then the predetermined overhead rate would be $10 per direct labor hour ($100,000 / 10,000 hours). Every time a furniture piece requires one labor hour to produce, it will be assigned $10 of overhead costs.
Construction Industry: A construction company can use the predetermined overhead rate to allocate overhead costs to different construction projects. If the firm estimates its total overhead costs to be $500,000 and total direct labor hours to be 25,000 hours in the coming year, the predetermined overhead rate would be $20 per direct labor hour ($500,000 / 25,000 hours). This means every project is assigned $20 of overheads for each direct labor hour spent on it.
Bakery Business: A bakery may use the predetermined overhead rate to allocate overhead costs to its various baked products. Suppose the bakery estimates total overhead costs to be $150,000 in the forthcoming year, and total direct labor hours to be 15,000 hours. Then, the predetermined overhead rate would be $10 per direct labor hour ($150,000 / 15,000 hours). Consequently, for every hour spent baking bread, cakes, etc, $10 of overhead costs are assigned to that product.
FAQs – Predetermined Overhead Rate Formula
What is the Predetermined Overhead Rate Formula?
The Predetermined Overhead Rate Formula is a formula used in cost accounting to allocate a certain amount of manufacturing overhead costs to the goods produced. The formula is: Predetermined Overhead Rate = Estimated Overhead / Estimated Activity.
Why is the Predetermined Overhead Rate Formula used?
The Predetermined Overhead Rate Formula is primarily used to estimate the overhead costs of production, thereby assisting companies in making pricing decisions and preparing financial statements. It aids in better cost control and budget planning.
How is the Predetermined Overhead Rate calculated?
To calculate the Predetermined Overhead Rate, first estimate the overhead costs for the year, then estimate the activity base (such as machine hours or labor hours). Divide the estimated overhead by the estimated activity to determine the rate.
What are the components of the Predetermined Overhead Rate Formula?
The Predetermined Overhead Rate Formula comprises two main components: the estimated manufacturing overhead cost, which is the numerator, and the estimation of the total quantity of the allocation base, which is the denominator.
What factors can impact the effectiveness of the Predetermined Overhead Rate Formula?
Several factors can impact the effectiveness of the Predetermined Overhead Rate Formula, including the quality of overhead cost and activity base estimates, changes in manufacturing processes and technology, price fluctuations in indirect materials, and changes in labor productivity.
Related Entrepreneurship Terms
- Cost Driver
- Job Order Costing
- Activity-based Costing
- Variable Overhead
- Fixed Overhead
Sources for More Information
- Investopedia: This is a trusted source for a diverse range of financial information, including the predetermined overhead rate formula.
- AccountingTools: AccountingTools provides a wide array of information related to accounting principles and calculations, including predetermined overhead rate formula.
- Corporate Finance Institute: CFI is a reliable source for advanced financial concepts and principles, including the predetermined overhead rate formula.
- Khan Academy: Khan Academy offers a variety of learning resources on different subjects, including finance and accounting, which may cover the predetermined overhead rate formula.
