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Understanding your company’s finances is an essential part of running a successful business. That’s why it’s important to get to know all of the different terminology relating to accounting, and how these financial metrics can be used to assess the financial health of your business. One such metric that you may have heard of is predetermined overhead rate.
What is predetermined overhead rate, exactly? In simple terms, it’s a kind of allocation rate that is used for estimated costs of manufacturing over a given period. It’s a good way to close your books quickly, since you don’t have to compile actual manufacturing overhead costs when you get to the end of the period. Keep reading to learn about how to find the predetermined overhead rate and what this means.
What is predetermined overhead rate?
As previously mentioned, the predetermined overhead rate is a way of estimating the costs that will be incurred throughout the manufacturing process. That means it represents an estimate of the costs of producing a product or carrying out a job. The estimate will be made at the beginning of an accounting period, before any work has actually taken place.
Big businesses may actually use different predetermined overhead rates in different production departments, as these may vary significantly. By having multiple rates like this, you can achieve a greater degree of accuracy. The downside is that it increases the amount of accounting labor and is therefore more expensive.
What information do you need to calculate predetermined overhead rate?
If you’re trying to make an estimate of manufacturing costs, you’re probably wondering how to determine predetermined overhead rate. There is some information that you will need to make these calculations.
First, you need to figure out which overhead costs are involved, and then create a total of this amount. If you have a large company, you may need to determine an allocation base for each department. Following this, you can assess which costs are similar and therefore which allocation base they belong to.
How to find the predetermined overhead rate
To calculate the predetermined overhead rate, there is a simple formula. You can calculate this rate by dividing the estimated manufacturing overhead costs for the period by the estimated number of units within the allocation base.
The period selected tends to be one year, and you can use direct labor costs, hours, machine hours or prime cost as the allocation base.
Example of predetermined overhead rate
The concept is much easier to understand with an example of predetermined overhead rate. For instance, imagine that your company has a new job coming up, and you need to calculate predetermined overhead rate for an estimate of manufacturing costs.
For this, you can take the average manufacturing overhead cost for the previous three months, and divide this by the machine hours in the current month. Let’s say this results in $40,000 dollars allocated to inventory. If you then find out later that in fact the actual amount that should have been assigned is $36,000 dollars, then the $4000 dollar difference should be charged to the cost of goods sold.
Problems with predetermined overhead rate
While it may be a useful financial figure, there are some limitations to the predetermined overhead rate. These include:
Risk of inaccuracy. The predetermined overhead rate is always based on estimates, and there is always a chance that the actual result will not line up with your calculated overhead rate.
If you have an inaccurate predetermined overhead rate and use this to make production and sales decisions, then this can have a knock-on effect on the success of your business.
There is also a danger of variance recognition problems. The difference between predetermined amounts of overhead and the actual figures may be charged to expense, which will have an impact on your profit and inventory asset.
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