4 4: Compute a Predetermined Overhead Rate and Apply Overhead to Production Business LibreTexts

Departmental overhead rates are needed because different processes are involved in production that take place in different departments. The following exercise is designed to help students apply their knowledge of the predetermined overhead rate in a business scenario. Companies need to make certain the sales price is higher than the prime costs and the overhead costs. In some industries, the company has no control over the costs it must pay, like tire disposal fees.

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Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units. Any difference between applied overhead and the amount of overhead actually incurred is called over- or under-applied overhead. Of course, management also has to price the product to cover the direct costs involved in the production, including direct predetermined overhead rate labor, electricity, and raw materials. A company that excels at monitoring and improving its overhead rate can improve its bottom line or profitability. Direct costs are costs directly tied to a product or service that a company produces. Direct costs include direct labor, direct materials, manufacturing supplies, and wages tied to production.

Concerns Surrounding Predetermined Overhead Rates

In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation. The difference between the actual and predetermined amounts of overhead could be charged to expense in the current period, which may create a material change in the amount of profit and inventory asset reported. This can be avoided to some extent by regularly adjusting the predetermined overhead rate to align with actual costs. Since both the numerator and denominator of the calculation are comprised of estimates, it is possible that the result will not bear much resemblance to the actual overhead rate. To keep this from being an issue, base the estimates on recent actual history, adjusted for your best estimate of production activity in the near future. Overhead costs are incurred whether the company is producing a large or small quantity of products or services.

Allocation Bases

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• In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation.
• This allocation can come in the form of the traditional overhead allocation method or activity-based costing..
• Examples of manufacturing overhead costs include indirect materials, indirect labor, manufacturing utilities, and manufacturing equipment depreciation.
• Based on the given information, calculate the predetermined overhead rate of TYC Ltd.

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. If you’d like to learn more about calculating rates, check out our in-depth interview with Madison Boehm.

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Unexpected expenses can be a result of a big difference between actual and estimated overheads. Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. From the above list, salaries of floor managers, factory rent, depreciation and property tax form part of manufacturing overhead. For example, if ABC Manufacturing’s actual manufacturing overhead was $100,000 but their applied manufacturing overhead was only $60,000, they underapplied $40,000. Conversely, if the actual manufacturing overhead was $100,000 but their applied manufacturing overhead was $120,000, they overapplied by $20,000. Finance Strategists has an advertising relationship with some of the companies included on this website.

4: Compute a Predetermined Overhead Rate and Apply Overhead to Production

To ensure that the company is profitable, an additional cost is added and the price is modified as necessary. In this example, the guarantee offered by Discount Tire does not include the disposal fee in overhead and increases that fee as necessary. Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour. Therefore, the predetermined overhead rate of TYC Ltd for the upcoming year is expected to be $320 per hour.

4 Compute a Predetermined Overhead Rate and Apply Overhead to Production

• For example, if we choose the labor hours to be the basis then we will multiply the rate by the direct labor hours in each task during the manufacturing process.
• Enter the total manufacturing overhead cost and the estimated units of the allocation base for the period to determine the overhead rate.
• At the end of the year, the amount of overhead estimated and applied should be close, although it is rare for the applied amount to exactly equal the actual overhead.
• Until now, you have learned to apply overhead to production based on a predetermined overhead rate typically using an activity base.
• This activity base is often direct labor hours, direct labor costs, or machine hours.

A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost. This allocation can come in the form of the traditional overhead allocation method or activity-based costing.. A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base. The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product.

• A company’s manufacturing overhead costs are all costs other than direct material, direct labor, or selling and administrative costs.
• Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.
• Figure 4.18 shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl.
• Prior to the start of the accounting year, JKL Corp calculates the predetermined annual overhead rate to be used in the new year.
• A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead.

To calculate the predetermined overhead rate using direct labor costs, the estimated manufacturing overhead costs would be divided by the allocation base which would be, in this case, the direct labor costs. The result of this calculation will be the predetermined overhead rate based upon the direct labor costs. The estimated or budgeted overhead is the amount of overhead determined during the budgeting process and consists of manufacturing costs but, as you have learned, excludes direct materials and direct labor.

Predetermined Overhead Rate: Formula, Applications & Limitations

Manufacturing decisions may be influenced by what the predetermined overhead rate, rather than the true production, needs. If the predetermined overhead rate is overapplied or underapplied, the potential product demand may be miscalculated as well. Figure 4.18 shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl.