Importance of Overhead
When companies manufacture products, sell merchandise, or provide services, they experience a variety of costs in the process. Some of those costs are directly related to a specific process, such as direct labor, direct materials, and billable (to the customer) costs, while others are not. Overhead is the name given to those expenses that are not directly related to any specific task or job. Examples of overhead costs include rent, utilities, office supplies, and administrative salaries.
Overhead rate is a percentage used to calculate an estimate for overhead costs on projects that have not yet started. It involves taking a cost that is known (such as the cost of materials) and then applying a percentage (the predetermined overhead rate) to it in order to estimate a cost that is not known (the overhead amount).
Overhead costs are incurred whether the company is producing a large or small quantity of products or services. This concept is important because these costs must be estimated in order to properly provide accurate prices to future customers. If overhead is overestimated, then prices will be too high and that can cause customers to seek their products or services from other companies (most likely their competitors). If overhead is underestimated, then the company may set their prices too low and not earn profits or experience a loss.
Overhead for a particular division, product, or process is commonly linked to a specific allocation base. Allocation bases are known amounts that are measured when completing a process, such as labor hours, materials used, machine hours, or energy use. The more consistency there is between the total overhead and the allocation base, the more accurate the estimate of predetermined overhead will be.
Computing the Predetermined Overhead Rate
There are some things that are needed in order to figure out an accurate predetermined overhead rate. The more historical data that a company has, the better off that they will be when computing predetermined rates. It is also possible (and often recommended) for a company to use different methods depending on the specific products, processes, and services within the organization.
Managers and accounting personnel should work together to analyze the historical overhead information to look for relationships between the total overhead and one of the specific allocation bases. A manager may notice that the overhead rate is usually about one and a half times the cost of direct labor for a given project. If this is consistent for many projects in that department over the past year, then predetermined overhead for that department would be computed by multiplying the estimated cost for direct labor by 150%.
Formula and Example
The predetermined overhead rate is found by taking the total estimated overhead costs and dividing by the estimated activity base. That probably makes little sense so let us look at a summary of steps and then apply it to an example.
Summary of Steps:
- Gather total overhead and amounts spent on various allocation bases for prior year(s)
- Look for consistent relationships between one or more of the allocation bases (i.e. direct materials) and the total overhead
- Select one allocation base to use for your selected department, division, product, or process
- Divide the total overhead costs by the total spent in that allocation base, which gives you the predetermined allocation rate (percentage)
- Multiply the predetermined allocation rate by the amount spent on the allocation base to estimate total overhead
You and the other managers at XYZ, Inc. have reviewed the historical overhead rates within your division and found that there is a link between the amount spent on materials to make your product and the total overhead. Last fiscal year, the total overhead cost was $553,000 and direct materials cost was $316,000. Using the formula, you divide the total overhead cost ($553,000) by the activity base ($316,000), we get an allocation rate of 1.75 (175%). In this case, these numbers are not estimated because they are historical figures.
For the last three years, your team found that the total overhead rate has been between 1.7 and 1.8 times higher than the direct materials rate. As such, you and your peers have agreed to set the predetermined overhead rate at 175% of the direct materials rate.
Now that you have this information, how can you apply it?
On your current project (coded as J-17), your division has spent $2,600 on direct materials; therefore, the predetermined overhead for this project will be $4,550 ($2,600 times 175%). The actual amount of total overhead will likely be different by some degree, but your job is to provide the best estimate for each project by using the predetermined overhead rate that you just computed.
The journal entry to reflect this estimate would be a debit to Goods in Process Inventory (Project J-17) for $4,550 and a credit for the same amount to Factory Overhead.
Overhead costs are those expenses that cannot be directly attached to a specific product, service, or process. Allocation bases (such as direct labor, direct materials, machine hours, etc.) are used when finding a relationship with total overhead costs. To estimate overhead costs we take the total overhead and divide it by the allocation base to come up with an allocation rate (percentage) and then multiply the allocation rate by the amount spent on the allocation base to estimate total overhead..
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Predetermined Overhead Rate - A Practical Exercise
The following exercise is designed to help students apply their knowledge of the predetermined overhead rate in a business scenario.
You are a managerial accountant working for Lazy Beds Inc, a small business that produces custom-made mattresses for its customers based on the customers' height, weight, and posture. It takes Lazy Beds a few weeks to make every single bed since there is a lot of craftsmanship involved. You receive a call from the chief financial officer, who says:
"We usually price our beds at the product cost plus a 50% markup. We set the price of the bed at the beginning when we quote the client. I have noticed that our gross profit margin is well below 50%, so I figured something was wrong. Upon further investigation, I noticed that our team is able to accurately predict the direct labor cost and materials cost, but it cannot predict the overhead cost properly. I don't blame them; it's hard to know what portion of our utility or rent bills should go to a single job. Can you calculate a predetermined overhead rate for us? It will help us quote more accurately. Let's use direct labor hours as a base because the more craftsmanship that is required for a bed, the more tools that are used and time that is required, which is linked to our electricity and rent charges."
You receive the following information from the previous year:
|Total materials consumed last year||$15,000,000|
|Direct labor cost last year||$30,000,000|
|Average hourly rate for direct labor||$40 per hour|
|Total overhead consumed last year||$1,500,000|
Compute the predetermined overhead rate for the company (Hint: You will need to first determine the number of direct labor hours!)
Step 1: Direct labor hours
Direct labor hours = Direct labor $ / Direct labor wage
Step 2: Predetermined Overhead Rate
Predetermined Overhead Rate = Total overhead consumed last year / Direct labor hours for last year
= 1,500,000 / 750,000
=$2 per direct labor hour
Therefore, the predetermined overhead rate is $2 per direct labor hour.
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