A pre-determined overhead rate is the rate used to apply

manufacturing Manufacturing is the creation or production of goods with the help of equipment, labor, machines, tools, and chemical or biological processing or formulation. It is the essence of secondary sector of the economy. The term may refer to a r ...

overhead to work-in-process

inventory Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the shap ...

. The pre-determined overhead rate is calculated before the period begins. The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period. The second step is to estimate the total

manufacturing cost Manufacturing cost is the sum of costs of all resources consumed in the process of making a product. The manufacturing cost is classified into three categories: direct materials cost, direct labor cost and manufacturing overhead. It is a factor in ...

at that level of activity. 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 According to the most simple definition, a cost driver is the unit of an activity that causes a change in the activity's cost: A different meaning is assigned to the term by Michael Porter: "cost drivers are the structural determinants of the cost ...

or activity base. Common activity bases used in the calculation include direct

labor costs A wage is payment made by an employer to an employee for work done in a specific period of time. Some examples of wage payments include compensatory payments such as ''minimum wage'', ''prevailing wage'', and ''yearly bonuses,'' and remunerat ...

, direct labor hours, or

machine A machine is a physical system using Power (physics), power to apply Force, forces and control Motion, movement to perform an action. The term is commonly applied to artificial devices, such as those employing engines or motors, but also to na ...

hours. This is related to an activity rate which is a similar calculation used in

Activity-based costing Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore, this model assigns more ind ...

. A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead. 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.

The Need for a Pre-determined Rate

Instead of using a pre-determined rate based on estimates, why not base the overhead rate on the actual total

manufacturing overhead cost Manufacturing overhead costs (MOH cost) are all manufacturing costs that are related to the cost object (work in process and then finished goods) but cannot be traced to that cost object in an economically feasible way. Examples include supplies, ...

and the actual total amount of the activity base incurred on a monthly, quarterly, or annual basis? If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate. For example, the costs of heating and cooling a factory in Illinois will be highest in the winter and summer months and lowest in the spring and fall. If the overhead rate is recomputed at the end of each month or each quarter based on actual costs and activity, the overhead rate would go up in the winter and summer and down in the spring and fall. As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs. Many managers{{who?, date=May 2019 believe that such fluctuations in product costs serve no useful purpose. To avoid such fluctuations, actual overhead rates could be computed on an annual or less-frequent basis. However, if the overhead rate is computed annually based on the actual costs and activity for the year, the manufacturing overhead assigned to any particular job would not be known until the end of the year. For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems. The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed. In recent years increased

automation Automation describes a wide range of technologies that reduce human intervention in processes, namely by predetermining decision criteria, subprocess relationships, and related actions, as well as embodying those predeterminations in machines ...

in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation.

How to find the overhead rate

To find the overhead rate, first determine the right

basis Basis may refer to: Finance and accounting * Adjusted basis, the net cost of an asset after adjusting for various tax-related items *Basis point, 0.01%, often used in the context of interest rates * Basis trading, a trading strategy consisting ...

that will describe the best the behavior of the cost. Then, divide the total budgeted overhead by the basis to calculate the overhead rate: Overhead Rate = (Total budgeted overhead / Basis)

What is the right basis to use to calculate the overhead rate

There are many ways that can be used to determine the right basis for a given order. These bases are: * Direct Labor Cost: this basis is used when manufacturing is labor-intensive. * Direct Labor Hours: it is used When workers are paid on the basis of their working hours. * Prime Cost: the prime cost is used when the factory produces only one kind of product. * Machine time: this basis is used when manufacturing is mostly automated.

How to calculate the Overhead budget using the rate

In order to find the overhead rate we will use the same basis that we have chosen by multiplying this basis by the calculated rate. 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. The share of the order of the overhead = Overhead Rate * Resources consumed

Sources

Fundamentals of Cost Accounting. William N. Lanen, Shannon W. Anderson, Michael W. Maher. McGraw-Hill.

External links

Accounting note on predetermined overhead ratehttp://www.accountingformanagement.org/predetermined-overhead-rate/
Business terms Management accounting