How to Calculate Predetermined Overhead Rate: Formula & Uses

The formula for a predetermined overhead rate is expressed as a ratio of the estimated amount of manufacturing overhead to be incurred in a period to the estimated activity base for the period. Take, for instance, a manufacturing company that produces gadgets; the production process of the gadgets would require raw material inputs and direct labor. These two factors would definitely make up part of the cost of producing each gadget. The company, having calculated its overhead costs as $20 per labor hour, now has a baseline cost-per-hour figure that it can use to appropriately charge its customers for labor and earn a profit. That is, the company is now aware that a 5-hour job, for instance, will have an estimated overhead cost of $100.

Can be Used in the Budgeting Process

Once an overhead rate is calculated using the given formula, it’s absorbed in the cost card of the business using the actual level of the activity. At the end of the accounting period, the actual indirect cost is obtained and compared with the absorbed indirect. The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed. In recent years increased automation in manufacturing operations has resulted petty cash in a trend towards machine hours as the activity base in the calculation. Many accountants always ask about specific time which we need to do this, at what point in time is the predetermined overhead rate calculated.

• When there is a big difference between the actual and estimated overheads, unexpected expenses will definitely be incurred.
• Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals.
• After almost a decade of experience in public accounting, he created MyAccountingCourse.com to help people learn accounting & finance, pass the CPA exam, and start their career.
• Commonly, the manufacturing overhead cost for machine hours can be ascertained from the predetermined overhead rate in the manufacturing industry.
• Suppose the estimated manufacturing overhead cost is $ 250,000 and the estimated labor hours is 2040.

Predetermined Overhead Rate (Definition, Example, Formula, and Calculation)

Keep reading to learn about how to find the predetermined overhead rate and what this means. One of the advantages of predetermined overhead rate is that businesses can use it to help with closing their books more quickly. This is because using this rate allows them to avoid compiling actual overhead costs as part of their closing process.

How to calculate the predetermined overhead rate

However, the problem with absorption/traditional costing is that we have to ignore individual absorption bases and absorb all overheads using a single level of activity. Hence, this is a compromise on the accuracy of the overall allocation process. On the other hand, the ABC system is more complex and requires extensive administrative work. The most prominent concern of this rate is that it is not realistic being that it is based on predetermined overhead rate formula estimates. Since the numerator and denominator of the POHR formula are comprised of estimates, there is a possibility that the result will not be close to the actual overhead rate. The fact is production has not taken place and is completely based on previous accounting records or forecasts.

Businesses need to calculate the costs of a product before the actual results can be determined due to several reasons. 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. 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. These overhead costs involve the manufacturing of a product such as facility utilities, bookkeeping and payroll services facility maintenance, equipment, supplies, and labor costs.