How to calculate the predetermined overhead rate
The predetermined overhead rate is an essential component of cost accounting. It helps managers allocate indirect costs, such as rent, utilities, and salaries, to specific products or jobs. Understanding how to calculate the pre-determined overhead rate will give you a clearer picture of your product’s actual cost and make informed decisions for pricing and production.
In this article, we will guide you through the process of calculating the predetermined overhead rate step-by-step.
Step 1: Identify the Indirect Costs
The first step in calculating the predetermined overhead rate is identifying your company’s indirect costs. These are expenses not directly linked to a particular product but are essential for running the business, like rent, insurance, utilities, and supervisor salaries.
Create a list of these indirect costs and sum them up to get your total overhead.
Step 2: Choose an Allocation Base
Next, you need to choose an allocation base that you will use to distribute the overhead among products or job orders. The allocation base should be a factor that has a relationship with the overhead expenses. Common allocation bases include direct labor hours, direct labor cost, and machine hours.
Step 3: Calculate Budgeted Allocation Base
Estimate the total amount of your chosen allocation base for the upcoming period. For example, if you’re using direct labor hours as an allocation base and expect to have 10,000 direct labor hours in the next year, then your budgeted allocation base is 10,000 hours.
Step 4: Calculate the Predetermined Overhead Rate
Now that you have both total budgeted overhead costs and the budgeted allocation base, it’s time to determine the predetermined overhead rate. Divide total budgeted overhead costs by budgeted allocation base:
Predetermined Overhead Rate = Total Budgeted Overhead / Budgeted Allocation Base
For our example:
Predetermined Overhead Rate = Total Budgeted Overhead / 10,000 hours
Assuming the total overhead cost was $200,000, the predetermined overhead rate now is:
Predetermined Overhead Rate = $200,000 / 10,000 hours = $20 per direct labor hour
Step 5: Apply the Predetermined Overhead Rate
Finally, apply the predetermined overhead rate to individual jobs or products. Multiply the rate by the actual amount of allocation base used in each job, which will give you the allocated overhead cost for that job.
For example, if a particular job required 100 direct labor hours:
Allocated Overhead Cost = Predetermined Overhead Rate x Actual Direct Labor Hours
Allocated Overhead Cost = $20 x 100 hours = $2,000
The allocated overhead cost of $2,000 would then be added to this job’s direct costs to arrive at a total cost for that specific job.
In conclusion, calculating the predetermined overhead rate allows businesses to allocate indirect costs more accurately and consistently among all jobs or products. By following these steps, you can now compute your pre-determined overhead rate and make better-informed financial decisions.