Written By:
Lisa Borga

## What is Predetermined Overhead Rate?

A predetermined overhead rate is an allocation rate that is used to apply an estimated cost of manufacturing overhead to either products or job orders.

This rate is usually calculated at the start of an accounting period by dividing the cost of manufacturing overhead by the activity driver, which is also sometimes referred to as the activity base or allocation base.

Common examples of activity drivers are machine hours, direct materials, or direct labor hours.

## Formula for Predetermined Overhead Rate

The predetermined overhead rate can be calculated by using the following formula:

Predetermined Overhead Rate = Estimated Cost of Manufacturing Overhead / Estimated Activity Driver

Now, let’s take a look at this formula in action with some examples.

## Examples of Predetermined Overhead Rate

### Example 1

Ralph’s Machine Tools Company assigns manufacturing overhead costs based on direct labor and applies this rate to job orders.

Ralph’s Machine Tools Company had an estimated manufacturing overhead cost of \$15,000 for the upcoming year.

The direct labor hours it expects for the upcoming year are 2,000.

This information can be used to calculate the predetermined overhead rate.

Estimated manufacturing overhead cost/Estimated total units in the allocation base = Predetermined overhead rate

The predetermined overhead rate for Ralph’s Machine Tools Company is:

\$15,000/2,000 hours = \$7.50 per direct labor hour.

The formula used to compute the predetermined overhead rate uses estimates.

This means that the overhead that is applied to jobs or products is different than the actual overhead from the product or job.

The adjustment made to eliminate this difference at the end of the period is called the disposition of over or underapplied overhead.

### Example 2

Dorothy’s Hat Company computed a predetermined overhead rate based on annual machine hours.

At the start of 2021, Dorothy’s Hat Company estimated that the total manufacturing overhead cost for the year would be \$320,000, and the total machine hours would be 50,000 hours.

The company actually had \$300,000 in total manufacturing overhead costs for the year, and the actual machine hours used were 53,000.

Now, compute the predetermined overhead rate for 2021.

Determine the manufacturing overhead costs that Dorothy should have applied to her hats.

Estimated manufacturing overhead cost/Estimated machine hours

\$320,000/50,000 hours = \$6.40 per machine hour

Actual machine hours used x Predetermined overhead rate

53,000 * \$6.40 = \$339,200

### Example 3

The operating and cost data are given next for three separate companies.

The companies use different allocation bases when calculating their predetermined overhead rates.

 Company 1 Company 2 Company 3 Direct Labor Hours 95,000 120,000 150,000 Machine Hours 140,000 80,000 110,000 Direct Materials Cost \$800,000 \$600,000 \$900,000 Manufacturing Overhead Cost \$1,000,000 \$860,000 \$1,110,000

Company 1: Machine hours

Company 2: Direct materials cost

Company 3: Direct labor hours

Next, calculate the predetermined overhead rate for the three companies above.

Company 1

Estimated manufacturing overhead cost/Estimated machine hours

\$1,000,000/140,000 hours = \$7.14

Company 2

Estimated manufacturing overhead cost/Estimated direct materials cost

\$860,000/\$600,000 = \$1.43

Company 3

Estimated manufacturing overhead cost/Estimated direct labor hours

\$1,110,000/150,000 = \$7.40

The predetermined overhead rate as calculated above is a plant-wide overhead rate or a single predetermined overhead rate.

This rate is generally only used by small companies.

Large companies will typically have a predetermined overhead rate for each production department.

Using multiple predetermined overhead rates is more complicated and takes more time, but it is generally thought to be more accurate than using a single predetermined overhead rate for the entire plant.

### Example 4

The Holiday Candy Company uses a job-order costing system and calculates different predetermined overhead rates for its molding and packaging departments.

These are the estimates the company computed at the start of 2021.

#### Molding Department

Direct labor hours: 5,000

Machine hours: 25,000

Direct labor cost: \$50,000

#### Packaging Department

Direct labor hours: 24,000

Machine hours: 7,000

Direct labor cost: \$240,000

The molding department bases its overhead rate on its machine hours. Whereas the packaging department bases its overhead rate on labor hours.

Now, calculate the predetermined overhead rate for the departments listed above.

Molding Department

The overhead rate for the molding department is computed by taking the estimated manufacturing overhead cost and dividing it by the estimated machine hours.

Overhead rate for the molding department = estimated manufacturing overhead cost/ estimated machine hours

\$150,000/25,000 hours = \$6 per machine hour

The overhead rate for the molding department is \$6 per machine hour.

Packaging Department

The overhead rate for the packaging department is calculated by taking the estimated manufacturing overhead cost and dividing it by the estimated direct labor cost.

Estimated overhead for the finishing department = estimated manufacturing overhead cost/ estimated direct labor cost

\$528,000/\$240,000 = \$2.20 per dollar of direct labor

The overhead rate for the packaging department is \$2.20 per dollar of direct labor.

This means the manufacturing overhead cost would be applied at 220% of the company’s direct labor cost.

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1. Harper College "Job Costing and Overhead" Page 1 - 16. December 9, 2021

2. Alamo Colleges District "Accounting Notes" Page 1 - 4. December 9, 2021

3. Mercer County Community College "Managerial Accounting" Page 1 - 67. December 9, 2021