Why predetermined overhead rates are used
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A predetermined overhead rate is an allocation rate given for indirect manufacturing costs that are involved in the production of a product (or several products). Show
It is used to estimate future manufacturing costs. The estimate is made at the beginning of an accounting period, before the commencement of any projects or specific jobs for which the rate is needed. Formula for Predetermined Overhead RateThe predetermined overhead rate is calculated using the following formula:  Predetermined Overhead Rate: ExplanationThe formula for the predetermined overhead rate is purely based on estimates. Hence, the overhead incurred in the actual production process will differ from this estimate. This difference is calculated at the end of the accounting period. It is known as either over-absorption or under-absorption of overheads. To further understand the formula, consider the following steps:
Departmental overhead rates are needed because different processes are involved in production that take place in different departments. ExampleThis example helps to illustrate the predetermined overhead rate calculation. Company B wants a predetermined rate for a new product that it will be launching soon. Its production department comes up with the details of how much the overheads will be and what other costs will be incurred. The pricing details are as follows: ItemBaseAmountDirect laborBased on labor hours200,000Direct materialsBased on material units250,000Variable overheadBased on labor hours150,000Fixed overheadBased on labor hours350,000Direct labor hours2000Since we need to calculate the predetermined rate, direct costs are ignored. The total manufacturing overhead cost will be the variable overhead plus fixed overhead. That is to say: 150,000+350,000=500,000. Total Manufacturing Overhead = 500,000 Labor hours amount to 2,000. Therefore, the predetermined rate is: Total manufacturing overhead/Direct labor hours = 500,000/2,000= 250 per direct labor hour Therefore, this rate of 250 is used in the pricing of the new product. If we change the allocation base to machine hours, the predetermined rate would be based on machine hours. For example: ItemBaseAmountDirect laborBased on labor hours200,000Direct materialBased on material units250,000Variable overheadBased on labor hours150,000Fixed overheadBased on labor hours350,000Direct labor hours1000Direct machine hours4500Manufacturing overhead/Direct machine hours = 500,000/4,500 = 111.11 per direct labor hour The predetermined overhead rate calculation shown in the example above is known as the single predetermined overhead rate or plant-wide overhead rate. Different businesses have different ways of costing; some use the single rate, others use multiple rates, and the rest use activity-based costing. Small companies tend to use activity-based costing, whereas in larger companies, each department in which different processes of production take place typically computes its own predetermined overhead rate. While it may become more complex to have different rates for each department, it is still considered more accurate and helpful because the level of efficiency and precision increases. Concerns Surrounding Predetermined Overhead RatesThere are still many points to consider before using a predetermined rate. The rates aren’t realistic because they are based on accounting estimates. The production hasn’t taken place and is completely based on forecasts or previous accounting records, and the actual overheads incurred could turn out to be way different than the estimate. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. This can result in abnormal losses as well and unexpected expenses being incurred. Unexpected expenses can be a result of a big difference between actual and estimated overheads. Profits will be affected and assets may need to be worked beyond their capacity too. Furthermore, historical data is not always the best for predicting, estimating, and forecasting. Prices increase all the time and industry trends and consumer expectations are constantly changing. To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too. Why are predetermined overhead rates used at the beginning of the year?Typically, companies use this rate to close the books more quickly. The rate avoids collecting actual manufacturing overhead costs as part of the closing period. Note: an accountant must determine the difference between the estimated and actual amounts of overhead by the end of each fiscal year.
What is the advantage of predetermined overhead rate?The primary advantage of a predetermined overhead rate is to smooth out seasonal variations in overhead costs. These variations are to a large extent caused by heating and cooling costs, which, while high in the summer and winter months, are relatively low in the spring and fall.
Why must a company use predetermined overhead rates when using job order costing?However, predetermined overhead rates allow production managers to allocate overhead expenses as soon as production begins. Having this information when production begins allows managers to make better cost-based business decisions. These include cost-control assessments as well as pricing and budgeting decisions.
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