Definition
The predetermined overhead rate (also known as an overhead absorption rate) is a rate used to allocate a company’s estimated overhead costs to individual products or job orders based on a consistent formula. This rate is typically computed at the beginning of an accounting period using budgeted data and remains constant throughout the period. By applying this rate, businesses can standardize overhead cost distribution, facilitate better budgeting and financial planning, and streamline cost control processes.
\[ \text{Predetermined Overhead Rate} = \frac{\text{Estimated Total Overhead Costs}}{\text{Estimated Total Activity Base}} \]
The activity base could be direct labor hours, machine hours, or any other measurable factor that drives cost.
Examples
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Manufacturing Company: A factory estimated that its annual overhead costs will be $500,000. It expects to use 25,000 machine hours over the year. The predetermined overhead rate would be calculated as:
\[ \frac{$500,000}{25,000 \text{ machine hours}} = $20 \text{ per machine hour} \]
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Service Industry Example: A consulting firm estimates $200,000 in overhead costs for the year, with project hours estimated at 10,000 hours. The predetermined overhead rate would be:
\[ \frac{$200,000}{10,000 \text{ project hours}} = $20 \text{ per project hour} \]
Frequently Asked Questions (FAQs)
Why is a predetermined overhead rate necessary?
A predetermined overhead rate allows companies to allocate overhead costs to products and job orders consistently and predictably, aiding in the controlling and budgeting process.
How is the predetermined overhead rate applied throughout the year?
Once computed, the predetermined overhead rate is applied consistently to all job orders and products based on their activity base, such as machine hours or labor hours.
Can the predetermined overhead rate change during the year?
Typically, it remains constant throughout the year. Any significant variances are adjusted at year-end through overapplied or underapplied overhead entries.
What is the difference between predetermined overhead rate and actual overhead rate?
The predetermined overhead rate is based on estimated costs and used for budgeting and planning, whereas the actual overhead rate uses actual incurred costs and is known only at the end of the accounting period.
What happens if actual overhead costs are higher or lower than estimated?
If actual overhead costs differ from the estimated costs used to calculate the predetermined overhead rate, businesses may need to make adjustments at the end of the period to account for overapplied or underapplied overhead.
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Overapplied Overhead: Occurs when the overhead allocated to various jobs or products exceeds the actual overhead incurred.
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Underapplied Overhead: Happens when the overhead allocated to various jobs or products is less than the actual overhead incurred.
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Activity Base: A measurable factor used to allocate overhead costs, such as direct labor hours or machine hours.
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Absorption Costing: A costing method that includes all manufacturing costs (direct materials, direct labor, and both variable and fixed manufacturing overhead) in the cost of a product.
Online References
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan
- “Managerial Accounting” by Ray H. Garrison, Eric W. Noreen, and Peter C. Brewer
- “Accounting Principles” by Jerry J. Weygandt, Paul D. Kimmel, and Donald E. Kieso
Accounting Basics: Predetermined Overhead Rate Fundamentals Quiz
### What is a predetermined overhead rate primarily used for?
- [x] Allocating overhead costs to products or job orders.
- [ ] Calculating net income.
- [ ] Estimating direct material costs.
- [ ] Allocating direct labor costs.
> **Explanation:** The primary purpose of a predetermined overhead rate is to allocate overhead costs to products or job orders consistently and predictably.
### How is a predetermined overhead rate typically calculated?
- [ ] Based on actual overhead costs.
- [ ] Based on last year's sales revenue.
- [x] Using estimated overhead costs and an activity base.
- [ ] Based on the net profit of the company.
> **Explanation:** A predetermined overhead rate is calculated using estimated overhead costs divided by an estimated activity base, such as labor hours or machine hours.
### Why do companies use a predetermined overhead rate rather than actual overhead costs?
- [x] To facilitate better budgeting and cost control.
- [ ] To avoid paying taxes.
- [ ] To increase net income.
- [ ] To ensure higher sales prices.
> **Explanation:** Companies use a predetermined overhead rate to gain better control over budgeting and cost allocation, as actual overhead costs might fluctuate and are only known at the end of the period.
### When adjusting for overapplied overhead, what does it indicate?
- [ ] Costs were allocated too accurately.
- [x] Allocated overhead costs exceeded actual overhead costs.
- [ ] Actual overhead costs were higher than the allocated costs.
- [ ] Estimated overhead was lower than budgeted overhead.
> **Explanation:** Overapplied overhead means that the overhead allocated to products or job orders exceeded the actual overhead costs incurred.
### Which of the following is NOT an activity base opportunity to allocate overhead costs?
- [ ] Direct labor hours.
- [ ] Machine hours.
- [x] Sales revenue.
- [ ] Project hours.
> **Explanation:** Sales revenue is not an activity base used to allocate overhead costs. Direct labor hours, machine hours, and project hours are commonly used.
### What needs to be adjusted if there is underapplied overhead at the year-end?
- [ ] Sales revenue.
- [x] Cost of Goods Sold (COGS).
- [ ] Direct material costs.
- [ ] Variable selling expenses.
> **Explanation:** Any underapplied overhead is typically adjusted against Cost of Goods Sold (COGS) at the end of the year.
### Why would a predetermined overhead rate remain constant throughout the year?
- [ ] To adjust for seasonal fluctuations.
- [ ] To avoid recalculating rates regularly.
- [x] To promote consistency and predictability in cost allocation.
- [ ] To improve net profit.
> **Explanation:** A predetermined overhead rate is kept constant to maintain consistency and predictability in the allocation of overhead costs.
### If a company estimated $300,000 in overhead and used 50,000 direct labor hours, what is the predetermined overhead rate?
- [x] $6 per direct labor hour.
- [ ] $60 per direct labor hour.
- [ ] $5 per direct labor hour.
- [ ] $7 per direct labor hour.
> **Explanation:** Using the formula \\(\frac{\$300,000}{50,000 \text{ direct labor hours}} = \$6 \text{ per direct labor hour}\\).
### Can a predetermined overhead rate be recalculated during the year?
- [ ] Always.
- [x] No, it usually remains the same until period-end.
- [ ] Only if overhead costs double.
- [ ] If new machinery is added.
> **Explanation:** A predetermined overhead rate typically remains constant throughout the accounting period to ensure uniformity in cost allocation.
### What concept is closely aligned with the use of a predetermined overhead rate?
- [x] Absorption costing.
- [ ] Variable costing.
- [ ] Marginal costing.
- [ ] Direct costing.
> **Explanation:** The predetermined overhead rate is closely linked to absorption costing, which includes all manufacturing costs in the cost of a product.
Thank you for exploring the intricacies of the predetermined overhead rate through this structured guide and quiz. Continue enhancing your accounting knowledge for competitive advantage!
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