Ever found yourself puzzled over how much to budget for your factory costs before production even starts? Determining the predetermined manufacturing overhead rate is a key step in setting realistic product prices and controlling expenses. Get it right, and you’ll have tighter financial control and fewer surprises.
In this article, you’ll discover a clear, step-by-step guide to calculating this essential rate—plus tips and insights to help you apply it confidently in your own business.
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How to Find the Predetermined Manufacturing Overhead Rate
Determining how much indirect cost, or overhead, to assign to your company’s products can feel overwhelming. That’s where the predetermined manufacturing overhead rate comes in. This rate helps you estimate overhead costs (like factory rent, machine maintenance, and supervisor salaries) for every product you make—before actual costs are known. Mastering this calculation streamlines budgeting, pricing, and overall cost control.
Let’s break down exactly what the predetermined overhead rate is, how you can calculate it, and why it’s so valuable for your business or studies.
Understanding the Predetermined Overhead Rate
The predetermined manufacturing overhead rate (often called POHR) is a formula used in cost accounting to allocate estimated overhead costs to products or jobs before the actual costs are known. Companies use this rate to:
- Plan and control manufacturing costs efficiently
- Establish product pricing that reflects true costs
- Avoid surprises at the end of the accounting period
In simplest terms:
It tells you how much overhead cost to assign to each unit or hour of activity during production.
The Formula: Breaking It Down
Let’s start with the core formula:
Predetermined Overhead Rate = Estimated Total Manufacturing Overhead Costs / Estimated Total Allocation Base
Let’s clarify each part:
- Estimated Total Manufacturing Overhead Costs: This is your best prediction of all indirect production expenses for the coming period (like utilities, rent, indirect labor, depreciation).
- Estimated Total Allocation Base: This is the predicted total amount of the base you’ll use to distribute those costs. Common bases include direct labor hours, direct labor costs, or machine hours.
Example Bases:
- Direct labor hours (often used when production is labor-intensive)
- Machine hours (for automated environments)
- Direct labor cost
Your choice of allocation base should reflect a strong link to how your overhead costs are actually incurred.
Step-by-Step: How to Calculate the Predetermined Overhead Rate
Ready to calculate the POHR for your business or classroom example? Here’s a practical, step-by-step guide:
1. Estimate Total Manufacturing Overhead Costs
Pull together all the anticipated indirect costs for the upcoming period. Common overhead expenses include:
- Factory rent or property tax
- Utilities (electricity, water)
- Depreciation of equipment and buildings
- Factory supervisors’ salaries
- Maintenances and repairs
- Indirect materials and supplies
Look at historical financials, current contracts, and planned changes to get this figure.
2. Select an Appropriate Allocation Base
Choose a cost driver most closely tied to how overhead is incurred. Typical choices are:
- Direct labor hours
- Direct labor cost
- Machine hours
For example, if equipment is a major driver of your indirect costs, machine hours might be the best base.
3. Estimate Total Units of the Allocation Base
Project how many total allocation base units (e.g., direct labor hours or machine hours) you’ll require in the period. Use forecasts from your production plan, sales targets, or staffing schedules.
4. Apply the Formula
Plug your estimates into the formula:
Predetermined Overhead Rate = Estimated Total Overhead / Estimated Total Allocation Base
For example:
If your estimated overhead is $200,000 for the year, and you expect 40,000 direct labor hours:
$200,000 / 40,000 hours = $5 per direct labor hour
5. Use the Rate to Allocate Overhead
Once you have your predetermined rate, apply it as production happens. For instance, if a job takes 100 direct labor hours, you allocate:
100 hours x $5/hour = $500 in overhead for that job
Why Use a Predetermined Overhead Rate?
You may wonder—why not just wait for actual costs? Using a POHR has several benefits:
- Timeliness: Cost info is available right away during production, aiding planning and pricing.
- Consistency: Costs are applied in a uniform way, avoiding erratic swings between periods.
- Control: Encourages a thoughtful approach to cost estimation and management.
- Benchmarking: Deviations between applied and actual overhead can flag future cost issues.
Practical Example
Let’s run through a realistic scenario:
Scenario:
A furniture manufacturer estimates annual manufacturing overhead at $500,000. The company expects to use 50,000 machine hours for production.
- Estimated Overhead: $500,000
- Estimated Machine Hours: 50,000
Predetermined Overhead Rate:
$500,000 / 50,000 machine hours = $10 per machine hour
If Job #101 uses 80 machine hours, the applied overhead will be:
80 x $10 = $800
Key Benefits of the Predetermined Overhead Rate
- Budgeting & Planning: Companies can set more accurate budgets and bids for contracts.
- Job Costing: Helps assign overhead to specific jobs, supporting detailed job cost records.
- Financial Statements: Enables timely preparation of interim financials without waiting for actuals.
- Pricing: Aids in calculating product prices that ensure profitability.
Common Challenges and How to Overcome Them
While the POHR is highly useful, it’s not without challenges:
1. Getting Accurate Estimates
- Tip: Use a rolling average of several previous periods and account for upcoming changes (like new equipment or shifts in production volume).
2. Choosing the Best Allocation Base
- Tip: Analyze your overhead costs to identify what drives them. If direct labor is declining due to automation, machine hours may be a better option.
3. Dealing with Over- or Under-Applied Overhead
- Explanation: Actual costs will almost always differ from estimated ones.
- Remedy: At period-end, compare applied overhead to actual. Adjust the difference with a closing journal entry—often by adjusting cost of goods sold.
4. Changing Production Methods
- If you automate or change processes, review your overhead drivers and recalculate your POHR as needed.
5. Lumping Diverse Costs Together
- If your company makes different products, consider using separate rates for different departments or products (departmental or activity-based costing).
Tips and Best Practices
Want to ensure your predetermined rate is as accurate and useful as possible? Follow these tips:
- Review and update your overhead calculations each budgeting cycle.
- Involve department managers to get the best estimates for both costs and allocation basess.
- Use software or calculators to test different overhead scenarios.
- Reconcile applied and actual overhead periodically—not just once a year.
- Be transparent with your team about how and why you’re allocating overhead; it increases accuracy and buy-in.
Predetermined Overhead Rate in Different Industries
The principle behind the rate is the same everywhere, but the allocation base may differ:
- Manufacturing: Often uses machine hours or direct labor hours/cost.
- Construction: Usually relies on labor hours or job size.
- Service Industries: May use billable hours or revenue bases.
Always pick the base that best reflects the resources driving your indirect costs.
Practical Advice for Students and Professionals
- Students: Show all your steps in exam problems. State your chosen allocation base and justify why it’s suitable.
- Professionals: After each period, review how close your estimates were to actuals. Use findings to improve next period’s forecast.
Conclusion
Finding and using the predetermined manufacturing overhead rate is a cornerstone of effective cost accounting. Understanding this concept helps you control costs, accurately price products, and maintain financial health. By following the clear steps above and staying aware of challenges, you’ll use this important tool with confidence and precision—no matter your industry.
Frequently Asked Questions (FAQs)
1. What is the main purpose of a predetermined overhead rate?
The main purpose is to allocate indirect manufacturing costs to products or jobs during the accounting period, allowing for immediate and standardized application of overhead costs instead of waiting until actual expenses are known.
2. How often should the predetermined overhead rate be updated?
Typically, companies update their predetermined overhead rate annually during the budgeting process. However, it should also be reviewed and adjusted if there are significant changes in production volumes or overhead costs.
3. What happens if actual overhead differs from applied overhead?
If the applied overhead (using the predetermined rate) doesn’t match the actual overhead incurred, you have either over-applied or under-applied overhead. This difference is usually adjusted at period-end, often through the cost of goods sold.
4. Can a company use more than one overhead rate?
Yes, companies with multiple departments or diverse production processes often use separate overhead rates for each department, area, or cost pool. This ensures more accurate cost allocation.
5. What types of costs are included in manufacturing overhead?
Manufacturing overhead includes all indirect costs associated with production, such as factory rent, depreciation, equipment maintenance, indirect materials, supervisor salaries, and utilities. It does not include direct materials or direct labor.
