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Predetermined Overhead Rate: Formula & Example

Instructor
Anthony Aparicio

Tony taught Business and Aeronautics courses for eight years; he holds a Master's degree in Management and is completing a PhD in Organizational Psychology

Expert Contributor
Steven Scalia

Steven completed a Graduate Degree is Chartered Accountancy at Concordia University. He has performed as Teacher's Assistant and Assistant Lecturer in University.

Overhead costs can be very tricky to estimate but it is necessary to do so when job planning. There are a few ways to accomplish this and this lesson will discuss some of the ways to effectively compute a predetermined overhead rate. Updated: 05/08/2020

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.

Allocation Bases

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:

  1. Gather total overhead and amounts spent on various allocation bases for prior year(s)
  2. Look for consistent relationships between one or more of the allocation bases (i.e. direct materials) and the total overhead
  3. Select one allocation base to use for your selected department, division, product, or process
  4. Divide the total overhead costs by the total spent in that allocation base, which gives you the predetermined allocation rate (percentage)
  5. Multiply the predetermined allocation rate by the amount spent on the allocation base to estimate total overhead

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Additional Activities

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.

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:

ItemAmount
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

Exercise

Compute the predetermined overhead rate for the company (Hint: You will need to first determine the number of direct labor hours!)

Solution:

Step 1: Direct labor hours

Direct labor hours = Direct labor $ / Direct labor wage

=30,000,000/40

=750,000 hours

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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