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Formula to Calculate Predetermined Overhead Rate
A Predetermined Overhead rate shall be used to calculate an estimate on the projects that are yet to commence for overhead costs. It would involve calculating a known cost (like Labor cost) and then applying an overhead rate (which was predetermined) to this to project an unknown cost (which is the overhead amount). The formula for calculating Predetermined Overhead Rate is represented as follows.
Where,
- O/H is overhead
- Total base units could be the number of units or labor hours etc.
Predetermined Overhead Rate Calculation (Step by Step)
The predetermined overhead rate equation can be calculated using the below steps:
- Gather total overhead variables and the total amount spent on the same.
- Find out a relationship of cost with the allocation base, which could be labor hours or units, and further, it should be continuous.
- Determine one allocation base for the department in question.
- Now take a total of overhead cost and then divide the same by the allocation base determined in step 3.
- The rate computed in step 4 can also be applied to other products or departments.
Examples
Example #1
Suppose that X limited produces a product X and uses labor hours to assign the manufacturing overhead cost. The estimated manufacturing overhead was $155,000, and the estimated labor hours involved were 1,200 hours. You are required to compute a predetermined overhead rate.
Solution
Here the labor hours will be base units.
Use the following data for the calculation of a predetermined overhead rate.
- Manufacturing O/H Cost: 150000
- Labor hours (Total Base Unit): 1200
Calculation of the predetermined overhead rate can be done as follows:
=150000/1200
The predetermined Overhead Rate will be –
Predetermined Overhead Rate = 125 per direct labor hour
Example #2
Gambier is head of TVS Inc. He is considering the launch of the new product, VXM. However, he wants to consider the pricing for the same. Therefore, he has asked the production head to develop the details of costing based on existing product overhead costs to apply the same to product VXM while making its pricing decisions. The details from the production department are as follows:
| Particular | Units | Amount |
|---|---|---|
| Direct Labor | Based on labor hours | 235000 |
| Direct Material | Based on the number of units | 350000 |
| Variable Overhead | Based on labor hours | 145000 |
| Fixed Overhead | Based on labor hours | 420000 |
| Direct Labor Hours | 8500 | - |
The production head wants to calculate a predetermined overhead rate, as that is the main cost allocated to the new product VXM. Therefore, you are required to calculate the predetermined overhead rate.
As the production head wants to calculate the predetermined overhead rate, all the direct costs will be ignored, whether direct cost (labor or material).
Solution
Calculation of Total Manufacturing Overhead
The total manufacturing overhead cost will be variable overhead, and fixed overhead, which is the sum of 145,000 + 420,000 equals 565,000 total manufacturing overhead.
=145000+420000
Total Manufacturing Overhead = 565000
Here the labor hours will be base units
Calculation of the predetermined overhead rate can be done as follows:
=565000/8500
The predetermined Overhead Rate will be –
= 66.47 per direct labor hour
Hence, this predetermined overhead rate of 66.47 shall be applied to the pricing of the new product VXM.
Example #3
Company X and Company Y are competing to acquire a massive order as that will make them much recognized in the market, and also, the project is lucrative for both of them. After going to its terms and conditions of the bidding, it stated the bid would be based on the overhead rate percentage. Therefore, the one with the lower shall be awarded the auction winner since this project would involve more overheads. Both of the companies have reported the following overheads.
| Particular | Company A | Company B |
|---|---|---|
| Factory Rent | 35000 | 38500 |
| Factory Manager Salary | 120000 | 115000 |
| Utilities of Factory | 155670 | 145678 |
| Electricity Bill | 45009 | 51340 |
| Quality Assurance Department | 345600 | 351750 |
| Labour Hours per Unit | 2 hrs | 1.5 hrs |
| Number of Units Produced | 2000 | 2500 |
You must calculate the predetermined overhead rate based on the above information and determine the chances of which company is more?
Solution:
We shall first calculate the total manufacturing overhead cost for Company A
=35000+120000+155670+45009+345600
- Total Manufacturing Overheads = 701279
Total Labor Hours will be -
=2000*2
- Total Labor Hours =4000
Calculation of Predetermined Overhead Rate for Company A is as follows
=701279/4000
The predetermined Overhead Rate for Company A will be –
Predetermined Overhead Rate = 175.32
We shall first calculate the total manufacturing overhead cost for Company B
=38500 + 115000 + 145678 + 51340 + 351750
- Total Manufacturing Overheads = 702268
Total Labor Hours will be -
=2500*1.5
- Total Labor Hours =3750
Calculation of Predetermined Overhead Rate for Company B is as follows
=702268/3750
The predetermined Overhead Rate for Company B will be –
Predetermined Overhead Rate = 187.27
Hence, preliminary, company A could be the winner of the auction even though the labor hour used by company B is less, and units produced more only because its overhead rate is more than that of company A.
Relevance and Uses
Commonly, the manufacturing overhead cost for machine hours can be ascertained from the predetermined overhead rate in the manufacturing industry. However, in the case of machine production, this rate can be used to identify the expected costs, which shall allow the firm to allocate their financial resources properly, which are needed to ensure the efficient and proper working of operations and production. Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals.
Recommended Articles
This article has been a guide to the Predetermined Overhead Rate Formula. Here we discuss the calculation of the predetermined overhead rate using its formula and downloadable excel template. You can learn more about accounting from the following articles –
- Calculate Absorption Costing
- Formula of Overhead Ratio
- Activity-Based Costing Formula
- Fixed Cost Calculation
- Advantages of Cost Accounting
