The common allocation bases are direct labor hours, direct labor cost, machine hours, and direct materials. 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.

• The allocation base (also known as the activity base or activity driver) can differ depending on the nature of the costs involved.
• To conclude, the predetermined rate is helpful for making decisions, but other factors should be taken into consideration, too.
• The estimate is made at the beginning of an accounting period, before the commencement of any projects or specific jobs for which the rate is needed.
• The predetermined overhead rate calculation shown in the example above is known as the single predetermined overhead rate or plant-wide overhead rate.
• Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization.

A plantwide or single overhead rate is one method for allocating these indirect costs so you can set prices appropriately. A single overhead rate for assigning all of the manufacturing production and service department costs to products. This rate is less accurate than departmental rates if a company manufactures a diverse group of products. To calculate a predetermined overhead rate, divide the manufacturing overhead cost by the units of allocation. For example, if overhead totals $75,000 for a month and direct costs equal $125,000, you have an overhead rate of 0.6 or 60 cents of overhead for every dollar of direct costs. Multiply the direct cost of one unit by 0.6 to find the amount of overhead you should allocate per unit.

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For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours. With $2.00 of overhead per direct hour, the Solo product is estimated to have $700,000 of overhead applied. When the $700,000 of overhead applied is divided by the estimated production of 140,000 units of the Solo product, the estimated overhead per product for the Solo product is $5.00 per unit. The computation of the overhead cost per unit for all of the products is shown in Figure 6.4. A predetermined overhead rate is defined as the ratio of manufacturing overhead costs to the total units of allocation. A plant-wide overhead rate is often a single rate per hour or a percentage of some cost that is used to allocate or assign a company’s manufacturing overhead costs to the goods produced.

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. The predetermined overhead rate is set at the beginning of the year and is calculated as the estimated (budgeted) overhead costs for the year divided by the estimated (budgeted) level of activity for the year. This activity base is often direct labor hours, direct labor costs, or machine hours. Once a company determines the overhead rate, it determines the overhead rate per unit and adds the overhead per unit cost to the direct material and direct labor costs for the product to find the total cost.

In addition, changes in prices and industry trends can make historical data an unreliable predictor of future overhead costs. Finally, using a predetermined overhead rate can result in inaccurate decision-making if the rate is significantly different from the actual overhead cost. To calculate this number, identify the total direct cost of production and the total overhead costs for the month. For example, the recipe for shea butter has easily identifiable quantities of shea nuts and other ingredients. Based on the manufacturing process, it is also easy to determine the direct labor cost.

What is the Predetermined Overhead Rate Formula?

In this example, if the direct cost of one unit of a product is $80, multiplying $80 by 0.6 gives an overhead cost allocation of $48. You also need the total number of direct labor hours and the direct labor hours required to produce each product the plant manufactures. Per unit labor hours can be calculated by dividing the total labor hours used to manufacture each product by the number of units manufactured.

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The estimated total overhead costs are then divided by the estimated total of the allocation base. Let us take the example of ort GHJ Ltd which has prepared the budget for next year. The company estimates a is my car an asset or a liability 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.

What is a plant-wide overhead rate?

Next, multiply the overhead per labor hour by the number of labor hours used to produce each unit. Sales of each product have been strong, and the total gross profit for each product is shown in Figure 6.7. Using the Solo product as an example, 150,000 units are sold at a price of $20 per unit resulting in sales of $3,000,000. The cost of goods sold consists of direct materials of $3.50 per unit, direct labor of $10 per unit, and manufacturing overhead of $5.00 per unit.

With 150,000 units, the direct material cost is $525,000; the direct labor cost is $1,500,000; and the manufacturing overhead applied is $750,000 for a total Cost of Goods Sold of $2,775,000. So, for every hour of direct labor used to produce widgets and gizmos, XYZ Inc. will allocate $50 of manufacturing overhead costs. Another approach to calculating a single or plantwide overhead rate uses direct cost as a basis, rather than direct labor hours. If your company manufactures several products at different locations in your plant, each product has its own overhead expenses.

They also estimate that they will have a total of 10,000 direct labor hours for the same period. A plantwide overhead rate is a single predetermined overhead rate that a company uses to allocate all of its manufacturing overhead costs to its products or services. It’s called “plantwide” because it applies to the entire plant’s production activities rather than specific departments or activities. A portion of these indirect costs, such as rent, utilities and office expenses, must be allocated to each unit of production to arrive at an accurate estimate of the total cost of the unit. When a plantwide overhead rate is used, all items produced are allocated a share of the overhead based on a single parameter. A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base.

Instead of figuring overhead costs for each product, you can calculate plant-wide expenses. This averages the costs for all products, and gives you an overview of expenses for your entire manufacturing operation. Sometimes called the “predetermined overhead rate,” your plant-wide figure helps you understand your company profitability. In these situations, a direct cost (labor) has been replaced by an overhead cost (e.g., depreciation on equipment). Because of this decrease in reliance on labor and/or changes in the types of production complexity and methods, the traditional method of overhead allocation becomes less effective in certain production environments.

1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

Direct labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. Small companies tend to use activity-based costing, whereas in larger companies, each department in which different processes of production take place typically computes its own predetermined overhead rate. Hence, the overhead incurred in the actual production process will differ from this estimate.