how to calculate predetermined overhead rate

When the predetermined overhead rate is not exactly what the company estimated, the rate would be either overapplied or underapplied. Predetermined overhead rates are important because they provide a way predetermined overhead rate formula to allocate overhead costs to products or services. Predetermined overhead rates are essential to understand for eCommerce businesses as they can be used to price products or services more accurately.

how to calculate predetermined overhead rate

In addition, changes in prices and industry trends can make historical data an unreliable predictor of future overhead costs. Finally, using a predetermined overhead rate can result in inaccurate decision-making if the rate is significantly different from the actual overhead cost. The overhead rate for the molding department is computed by taking the estimated manufacturing overhead cost and dividing it by the estimated machine hours.

Example 2: eCommerce Business

Ahead of discussing how to calculate predetermined overhead rate, let’s define it. A predetermined overhead rate(POHR) is the rate used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner. This allocation process depends on the use of a cost driver, which drives the production activity’s cost. Examples can include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs. Direct labor hours are calculated by assessing the time employees spend directly on production activities, providing a basis for overhead rate calculations.

These costs cannot be easily traced back to specific products or services and are typically fixed in nature. The concept is much easier to understand with an example of predetermined overhead rate. For instance, imagine that your company has a new job coming up, and you need to calculate predetermined overhead rate for an estimate of manufacturing costs. That amount is added to the cost of the job, and the amount in the manufacturing overhead account is reduced by the same amount. At the end of the year, the amount of overhead estimated and applied should be close, although it is rare for the applied amount to exactly equal the actual overhead.

Predetermined Overhead Rate: Formula, Applications & Limitations

This is why a predetermined overhead rate is computed to allocate the overhead costs to the production output in order to determine a cost for a product. The predetermined overhead rate is, therefore, usually used for contract bidding, product pricing, and allocation of resources within a company, based on each department’s utilization of resources. The measures used to calculate overhead rate include machine hours or labor costs, with these costs used to determine how much indirect overhead is spent to produce products or services.

Leave a Reply

Your email address will not be published. Required fields are marked *