Predetermined Overhead Rate

A predetermined overhead rate is the rate a manufacturer uses to assign estimated manufacturing overhead to products or jobs during a period. It is set before the period begins by dividing the budgeted overhead cost by the budgeted amount of an allocation base, such as direct labor hours or machine hours. The rate is then applied to each job or batch as the work is done.

The rate exists because actual overhead costs, such as factory rent, utilities, supervision and equipment depreciation, are not known until the period ends, and many are incurred unevenly. An estimate lets a company cost jobs, set prices and value inventory as it goes. It is central to job order costing and normal costing, and the overhead charged with it is called applied overhead. Any difference from actual overhead is settled at period-end.

Picture a print shop that has to pay for rent, heating and machine repairs all year, but cannot say on any given day exactly how much of those bills a single print job caused. Waiting until December to work it out would make it impossible to quote prices during the year.

Instead, the owner makes a sensible guess in January: if the year's shared costs come to a certain amount and the machines will run for a certain number of hours, then each machine hour should carry a fixed share. Every job is charged that share for each hour it uses. At the end of the year the owner compares the total charged with the real bills and corrects the small gap.

The rate is calculated as:

Overhead is then applied to each job as the rate multiplied by the actual units of the base that the job uses.

A furniture maker budgets $480,000 of manufacturing overhead for the year and expects to run its machines for 32,000 hours. Its rate is $480,000 divided by 32,000, or $15 per machine hour. Job 214 uses 120 machine hours, so it is charged $1,800 of overhead. The entry debits work-in-process inventory $1,800 and credits Manufacturing Overhead $1,800.

By year-end the plant has actually run 31,000 machine hours, so applied overhead totals $465,000 (31,000 times $15). Actual overhead costs come to $472,000. Overhead is therefore underapplied by $7,000. If that amount is immaterial, it is closed to cost of goods sold with a debit to Cost of Goods Sold and a credit to Manufacturing Overhead of $7,000. If it is material, it is prorated among work in process, finished goods inventory and cost of goods sold.

The allocation base should be the activity that most closely drives overhead costs. Direct labor hours suit labor-intensive work, while machine hours suit automated plants where power, maintenance and depreciation follow machine use. A single plantwide rate is simple, but it can distort costs when departments use very different mixes of labor and machinery. Many manufacturers therefore use a separate departmental overhead rate for each production department, and some move further to activity-based costing, which uses a separate rate for each major activity, such as machine setups or quality inspections.

• Timeliness. Jobs must be costed and priced during the year, not months after they are finished.
• Seasonal costs. Heating bills in winter or air-conditioning in summer would make identical jobs look more or less costly depending on the month.
• Uneven volume. Fixed costs spread over fewer units in a slow month would push unit costs up for reasons that have nothing to do with the product.

An annual rate smooths these effects so that similar jobs carry similar overhead throughout the year. It is also closely linked to the budget, since the rate is only as good as the overhead and activity estimates behind it.

If budgeted costs or activity levels are badly wrong, product costs and prices will be misstated until the year-end adjustment. The choice of denominator also matters: a rate based on a low expected volume loads more fixed cost onto each unit. US GAAP inventory rules (ASC 330) require fixed production overhead to be allocated on the basis of the normal capacity of production facilities, so unusually low production does not inflate inventory values under absorption costing. In standard costing systems, differences caused by volume appear as a fixed manufacturing overhead volume variance.

• Financial Accounting Standards Board