A predetermined overhead rate is an allocation rate used to estimate the manufacturing costs of a product or job. It represents the estimated costs of producing a product or carrying out a job and is determined at the beginning of an accounting period [3].
Key Facts
- Definition: The predetermined overhead rate is an allocation rate used to estimate the manufacturing costs of a product or job. It represents the estimated costs of producing a product or carrying out a job and is determined at the beginning of an accounting period[3].
- Calculation: The predetermined overhead rate is calculated by dividing the estimated manufacturing overhead costs for a period by the estimated number of units within the allocation base[3]. The allocation base can be direct labor costs, hours, machine hours, or prime cost[3].
- Multiple Rates: Large businesses may use different predetermined overhead rates in different production departments to achieve greater accuracy. This means that each department may have its own predetermined overhead rate based on its specific allocation base.
- Limitations: The predetermined overhead rate is based on estimates and may not accurately reflect the actual overhead costs incurred during production[3]. Inaccurate rates can lead to incorrect production and sales decisions, impacting the success of the business. Variance recognition problems may also arise if there is a significant difference between the predetermined and actual overhead amounts.
Calculation
The predetermined overhead rate is calculated by dividing the estimated manufacturing overhead costs for a period by the estimated number of units within the allocation base [3]. The allocation base can be direct labor costs, hours, machine hours, or prime cost [3].
Multiple Rates
Large businesses may use different predetermined overhead rates in different production departments to achieve greater accuracy. This means that each department may have its own predetermined overhead rate based on its specific allocation base.
Limitations
The predetermined overhead rate is based on estimates and may not accurately reflect the actual overhead costs incurred during production [3]. Inaccurate rates can lead to incorrect production and sales decisions, impacting the success of the business. Variance recognition problems may also arise if there is a significant difference between the predetermined and actual overhead amounts.
Conclusion
The predetermined overhead rate is a useful tool for estimating manufacturing costs, but it is important to be aware of its limitations. By using accurate estimates and carefully considering the allocation base, businesses can use the predetermined overhead rate to make informed decisions about pricing, production, and sales.
References
[1] Study.com. (n.d.). Predetermined Overhead Rate: Formula & Example. Retrieved from https://study.com/academy/lesson/predetermined-overhead-rate-formula-example.html
[2] GoCardless. (2022, September). Guide to Predetermined Overhead Rate Formula. Retrieved from https://gocardless.com/en-us/guides/posts/predetermined-overhead-rate-formula/
[3] Finance Strategists. (2023, June 8). Predetermined Overhead Rate. Retrieved from https://www.financestrategists.com/accounting/cost-accounting/overhead-costing/predetermined-overhead-rate/
FAQs
What is a predetermined overhead rate?
A predetermined overhead rate is an allocation rate used to estimate the manufacturing costs of a product or job. It represents the estimated costs of producing a product or carrying out a job and is determined at the beginning of an accounting period.
How is the predetermined overhead rate calculated?
The predetermined overhead rate is calculated by dividing the estimated manufacturing overhead costs for a period by the estimated number of units within the allocation base. The allocation base can be direct labor costs, hours, machine hours, or prime cost.
Why do companies use different predetermined overhead rates for different production departments?
Large businesses may use different predetermined overhead rates in different production departments to achieve greater accuracy. This means that each department may have its own predetermined overhead rate based on its specific allocation base.
What are the limitations of using a predetermined overhead rate?
The predetermined overhead rate is based on estimates and may not accurately reflect the actual overhead costs incurred during production. Inaccurate rates can lead to incorrect production and sales decisions, impacting the success of the business. Variance recognition problems may also arise if there is a significant difference between the predetermined and actual overhead amounts.
How can companies improve the accuracy of their predetermined overhead rates?
Companies can improve the accuracy of their predetermined overhead rates by using accurate estimates and carefully considering the allocation base. They can also use multiple rates for different departments or activities to better reflect the actual costs.
What are some common allocation bases used for calculating the predetermined overhead rate?
Common allocation bases include direct labor costs, direct labor hours, machine hours, and prime cost. The choice of allocation base depends on the nature of the overhead costs and the production process.
How does the predetermined overhead rate affect the pricing of products or services?
The predetermined overhead rate is used to estimate the total manufacturing cost of a product or service. This cost is then used to determine the selling price of the product or service. An accurate predetermined overhead rate is important to ensure that the selling price covers all of the costs of production, including overhead costs.
How can companies use the predetermined overhead rate for decision-making?
Companies can use the predetermined overhead rate to make informed decisions about pricing, production, and sales. For example, they can use the rate to estimate the cost of producing a new product or service, or to compare the costs of different production methods.