Calculate Predetermined Overhead Rate

How to Calculate Predetermined Overhead Rate

Understanding the Basics

To accurately calculate the predetermined overhead rate (POR), you need two key pieces of information: the estimated manufacturing overhead costs and the allocation base. This rate helps in assigning overhead costs to products or job orders based on standard accounting practices.

Estimating Overhead Costs

Begin by estimating the total manufacturing overhead costs for a specific period. This could include all indirect costs related to production, such as utilities, rent, and salaries of supervisory staff.

Choosing an Allocation Base

Select an appropriate allocation base, which acts as the activity driver. Common examples include machine hours, direct labor hours, or direct materials costs. The choice of allocation base should reflect the principal cause of overhead costs in your operations.

Performing the Calculation

Calculate the predetermined overhead rate using the formula POR = estimated overhead costs / allocation base. This calculation provides a rate that can be applied to specific products or jobs to allocate overhead proportionally.

Application in Budgeting

Using the predetermined overhead rate aids in developing comprehensive budgets and setting financial benchmarks. It plays a crucial role in financial management by enabling the projection and control of overhead costs in production settings.

How to Calculate Predetermined Overhead Rate

The predetermined overhead rate is crucial for accurate cost accounting and efficient management of production costs. To calculate this rate, follow a structured three-step process.

Step 1: Estimate Manufacturing Overhead Costs

Begin by estimating the total manufacturing overhead costs for the period. This includes all costs related to the production process that are not direct materials or direct labor. Common components are the salaries of factory managers, factory rent, property taxes, and depreciation.

Step 2: Identify and Estimate the Activity Driver

The activity driver, also known as the allocation base, is the factor used to assign overhead costs to products. This could be machine hours, labor hours, or any other measure that reflects the use of manufacturing resources. Estimate the total amount of the chosen activity driver for the period.

Step 3: Calculate Predetermined Overhead Rate

Using the formula predetermined overhead rate = estimated overhead / allocation base, divide your estimated overhead costs by the estimated total of your chosen activity driver. For example, if the overhead is $15,000 and the base is 25,000 machine hours, the rate would be $0.60 per machine hour.

Setting accurate predetermined overhead rates aids in better product costing and efficiency in financial operations, ensuring that all production costs are accounted for systematically.

Examples of Calculating Predetermined Overhead Rate

Example 1: Simple Manufacturing Setup

To calculate the predetermined overhead rate in a manufacturing facility that expects $500,000 in factory overhead costs and 10,000 direct labor hours, use the formula: Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Activity Base. Plugging in the values, we get $500,000 / 10,000 hours = $50 per hour. This rate helps in assigning overhead costs to products based on the hours worked.

Example 2: Using Machine Hours

Consider a company that uses machine hours as its activity base. If the estimated overhead costs are $300,000 and the machine hours are anticipated to be 15,000 hours, the predetermined overhead rate is calculated as follows: $300,000 / 15,000 machine hours = $20 per machine hour. This method is suitable for companies where machine work is a major part of operations.

Example 3: Multiple Cost Drivers

A more complex scenario involves using multiple cost drivers. Assume a business has overhead costs of $750,000. It expects to utilize 25,000 direct labor hours and 50,000 machine hours. If the company splits the overhead equally between labor and machine hours, the calculation is performed separately for each driver. For labor: $375,000 / 25,000 hours = $15 per labor hour and for machines: $375,000 / 50,000 hours = $7.5 per machine hour. This approach is effective in diversified operational setups.

Example 4: Annual Budget Approach

In cases where a company plans its budget on an annual basis, the predetermined overhead rate can be determined by dividing total estimated overhead costs by the estimated annual production hours. For instance, with an overhead estimate of $1,000,000 and 40,000 production hours per year, the rate would be $1,000,000 / 40,000 hours = $25 per hour. This example illustrates a straightforward annual calculation.

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