Overhead Rate Meaning, Formula, Calculations, Uses, Examples

Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor. Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process. You can envision the potential problems in creating an overhead allocation rate within these circumstances. As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2).

• Remember that product costs consist of direct materials, direct labor, and manufacturing overhead.
• A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead.
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• This activity base is often direct labor hours, direct labor costs, or machine hours.
• If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions.

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• The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved.
• Traditionally, overheads have been absorbed in the product cost based on a single basis of apportionment.
• So, if you were to measure the total direct labor cost for the week, the denominator would be the total weekly cost of direct labor for production that week.
• To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too.
• On the other hand, the business with the machine incentive environment absorbs overhead based on the machine hours.

Costs must thus be estimated based on an overhead rate for each cost driver or activity. It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately. If a company prices its products so low that revenues do not cover its overhead costs, the business will be unprofitable.

Example 2: Cost per Hour

If the business used the traditional costing/absorption costing system, the total overheads amounting to $26,000 will be absorbed using labor hours. The use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or decline in these costs. This is a particular concern in highly competitive industries where production rates may vary dramatically, a single predetermined overhead rate is called a(n) based on the popularity of the latest round of product releases. 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.

• A later analysis reveals that the actual amount that should have been assigned to inventory is $48,000, so the $2,000 difference is charged to the cost of goods sold.
• The third step is to compute the predetermined overhead rate by dividing the estimated total manufacturing overhead costs by the estimated total amount of cost driver or activity base.
• To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC).
• This is related to an activity rate which is a similar calculation used in Activity-based costing.
• For example, a production facility that is fairly labor intensive would likely determine that the more labor hours worked, the higher the overhead will be.

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• Added to these issues is the nature of establishing an overhead rate, which is often completed months before being applied to specific jobs.
• Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization.
• Direct costs typically are direct labor, direct machine costs, or direct material costs—all expressed in dollar amounts.
• However, there is a strong need to constantly update the production level depending on the seasonal fluctuations and the factor affecting the demand of the product.
• For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems.

The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved. Complex overhead absorption is when multiple absorptions are required to allocate the cost of the support function. For instance, kitchen expenses first need to be allocated to the procurement department (a support department). It’s then further allocated to the departments that use the procurement facility.

A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year. The overhead rate allocates indirect costs to the direct costs tied to production by spreading or allocating the overhead costs based on the dollar amount for direct costs, total labor hours, or even machine hours.

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. 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). Using the planned annual amounts for the upcoming year reduces the fluctuations that would occur if monthly rates were used. The equation for the overhead rate is overhead (or indirect) costs divided by direct costs or whatever you’re measuring. Direct costs typically are direct labor, direct machine costs, or direct material costs—all expressed in dollar amounts.

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