Which of the following is the correct formula to compute the predetermined overhead rate?

Predetermined Overhead Rate Formula (Table of Contents)

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The term “predetermined overhead rate” refers to the allocation rate that is assigned to products or job orders at the beginning of a project based on the estimated cost of manufacturing overhead for a specific period of reporting. In other words, it provides an estimate of the expected cost to be incurred in producing a product or job order. The formula for the predetermined overhead rate can be derived by dividing the estimated manufacturing overhead cost by the estimated number of units of the allocation base for the period. Typically, direct labor cost, direct labor hours, machine hours or prime cost is used as the allocation base, while the period usually selected is one year. Mathematically, it is represented as,

Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period

Examples of Predetermined Overhead Rate Formula (With Excel Template)

Let’s take an example to understand the calculation of Predetermined Overhead Rate in a better manner.

Predetermined Overhead Rate Formula – Example #1

Let us take the example of a company named TYC Ltd that is engaged in the business of manufacturing automotive spare parts for two-wheelers. The company has budgeted the following cost for the upcoming year:

Further, the company uses direct labor hours to assign manufacturing overhead costs to products. As per the budget, the company will require 150,000 direct labor hours during the forthcoming year. Based on the given information, calculate the predetermined overhead rate of TYC Ltd.

Solution:

From the above list, salaries of floor managers, factory rent, depreciation and property tax form part of manufacturing overhead.

Estimated Manufacturing Overhead Cost is calculated using the formula given below

Estimated Manufacturing Overhead Cost = Salaries of Managers + Factory Rent + Depreciation + Property Tax

• Estimated Manufacturing Overhead Cost= $30 million + $10 million + $5 million + $3 million
• Estimated Manufacturing Overhead Cost = $48 million

Predetermined Overhead Rate is calculated using the formula given below

Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period

• Predetermined Overhead Rate = $48,000,000 / 150,000 hours
• Predetermined Overhead Rate = $320 per hour

Therefore, the predetermined overhead rate of TYC Ltd for the upcoming year is expected to be $320 per hour.

Predetermined Overhead Rate Formula – Example #2

Let us take the example of ort GHJ Ltd which has prepared the budget for next year. The company estimates a gross profit of $100 million on total estimated revenue of $250 million. As per the budget, direct labor cost and raw material cost for the period is expected to be $40 million and $60 million respectively. The company uses machine hours to assign manufacturing overhead costs to products. Calculate the predetermined overhead rate of GHJ Ltd if the required machine hours for next year’s production is estimated to be 10,000 hours.

Solution:

Estimated Manufacturing Overhead Cost is calculated using the formula given below

Estimated Manufacturing Overhead Cost = Total Estimated Revenue – Gross Profit – Direct Labor Cost – Raw Material Cost

• Estimated Manufacturing Overhead Cost = $250 million – $100 million – $40 million – $60 million
• Estimated Manufacturing Overhead Cost = $50 million

Predetermined Overhead Rate is calculated using the formula given below

Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period

• Predetermined Overhead Rate = $50,000,000 / 10,000 machine hours
• Predetermined Overhead Rate = $5,000 per machine hour

Therefore, the predetermined overhead rate of GHJ Ltd for next year is expected to be $5,000 per machine hour.

Explanation

The formula for the predetermined overhead rate can be derived by using the following steps:

Step 1: Firstly, determine the level of activity or the volume of production in the upcoming period.

Step 2: Next, determine the estimated manufacturing overhead cost for that level of activity in the forthcoming period. It includes all the indirect costs that are expected to be incurred in the process of production, however the same can’t be assigned directly to the product.

Step 3: Next, decide on the allocation base for the period, which can be direct labor cost, direct labor hours, machine hours or prime cost.

Step 4: Next, determine the estimated number of units of the allocation base for the upcoming period, which will be either in terms of hours for direct labor hours and machine hours or dollars for direct labor cost and prime cost.

Step 5: Finally, a formula for predetermined overhead rate can be derived by dividing the estimated manufacturing overhead cost (step 2) by the estimated number of units of the allocation base for the period (step 4) as shown below.

Predetermined Overhead Rate = Estimated Manufacturing Overhead Cost / Estimated Units of the Allocation Base for the Period

Relevance and Uses of Predetermined Overhead Rate Formula

The concept of predetermined overhead rate is very important because it is used most of the enterprises as it enables them to estimate the approximate total cost of each job. Larger organizations employ different allocation bases for determining the predetermined overhead rate in each production department. However, in recent years the manufacturing operations have started to use machine hours more predominantly as the allocation base.

However, one major disadvantage of the method is that both the numerator and the denominator are estimates and as such, it is possible that the actual result may vary significantly from the predetermined overhead rate.

Predetermined Overhead Rate Formula Calculator

You can use the following Predetermined Overhead Rate Formula Calculator

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