# How to Calculate Predetermined Overhead Rate: Formula & Uses

• A predetermined overhead rate, also known as a plant-wide overhead rate, is a calculation used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured.
• When the \$700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is \$5.00 per unit.
• Based on the given information, calculate the predetermined overhead rate of TYC Ltd.
• This concept is important because these costs must be estimated in order to properly provide accurate prices to future customers.
• Furthermore, historical data is not always the best for predicting, estimating, and forecasting.
• The predetermined overhead allocation rate formula is calculated by dividing the estimated manufacturing overhead cost by the allocation base.

If this is consistent for many projects in that department over the past year, then predetermined overhead for that department would be computed by multiplying the estimated cost for direct labor by 150%. Overhead for a particular division, product, or process is commonly linked to a specific allocation base. Allocation bases are known amounts that are measured when completing a process, such as labor hours, materials used, machine hours, or energy use. The more consistency there is between the total overhead and the allocation base, the more accurate the estimate of predetermined overhead will be. The concept of predetermined overhead rate is very important because it is used most of the enterprises as it enables them to estimate the approximate total cost of each job. Larger organizations employ different allocation bases for determining the predetermined overhead rate in each production department.

## Concerns Surrounding Predetermined Overhead Rates

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Its production department comes up with the details of how much the overheads will be and what other costs will be incurred. Small companies typically use activity-based costing, while large organizations will have departments that compute their own rates. Different businesses have different ways of costing; some use the single rate, others use multiple rates, and the rest use activity-based costing. Departmental overhead rates are needed because different processes are involved in production that take place in different departments.

If the predetermined overhead rate is overapplied or underapplied, the potential product demand may be miscalculated as well. Overhead costs are those expenses that cannot be directly attached to a specific product, service, or process. Allocation bases (such as direct labor, direct materials, machine hours, etc.) are used when finding a relationship with total overhead costs. To calculate the predetermined overhead, the company would determine what the allocation base is. The allocation base could be direct labor costs, direct labor dollars, or the number of machine-hours. The company would then estimate what the predetermined overhead cost would be and divide them to determine what the manufacturing overhead cost would be.

Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. After reviewing the product cost and consulting with the marketing department, the sales prices were set. The sales price, cost of each product, and resulting gross profit are shown in Figure 6.6. Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be \$5,000 per machine hour.

For the last three years, your team found that the total overhead rate has been between 1.7 and 1.8 times higher than the direct materials rate. As such, you and your peers have agreed to set the predetermined overhead rate at 175% of the direct materials rate. As the predetermined overhead rate is an estimate of what the company believes will be the cost for manufacturing the product, the actual costs could be different than what they estimated.

• Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too.
• In addition, changes in prices and industry trends can make historical data an unreliable predictor of future overhead costs.
• For the last three years, your team found that the total overhead rate has been between 1.7 and 1.8 times higher than the direct materials rate.
• Remember that product costs consist of direct materials, direct labor, and manufacturing overhead.
• Allocation bases (such as direct labor, direct materials, machine hours, etc.) are used when finding a relationship with total overhead costs.
• This activity base is often direct labor hours, direct labor costs, or machine hours.

As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2). Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead.

## Component Categories under Traditional Allocation

Furthermore, historical data is not always the best for predicting, estimating, and forecasting.