2 5: Actual Vs. Applied Factory Overhead Business LibreTexts

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. To account for these changes in technology and production, many organizations today have adopted an overhead allocation method known as activity-based costing (ABC). This chapter will explain the transition to ABC and provide a foundation in its mechanics. A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours.

Nonetheless, it is still essential for businesses to reconcile the difference between the actual overhead and the estimated overhead at the end of their fiscal year. In production, the predetermined overhead rate is computed to facilitate the determination of the standard cost for a product. 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. However, in recent years the manufacturing operations have started to use machine hours more predominantly as the allocation base.

1. A predetermined overhead rate is calculated at the start of the accounting period by dividing the estimated manufacturing overhead by the estimated activity base.
2. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles.
3. As a result, there is a high probability that the actual overheads incurred could turn out to be way different than the estimate.

The overhead used in the allocation is an estimate due to the timing considerations already discussed. One of the advantages of predetermined overhead rate is that it can help businesses monitor overhead rate. A business can calculate its actual costs periodically and then compare that to the predetermined overhead rate in order to monitor expenses throughout the year or see how on-target their original estimate was. This comparison can be used to monitor or predict expenses for the next project (or fiscal year). In larger companies, each department in which different production processes take place usually computes its own predetermined overhead rate. Despite the fact that it may become more complex, it is considered more accurate and helpful to have different predetermined overhead rates for each department, because the level of efficiency and precision increases.

Predetermined Overhead Rate (POHR): Formula and Calculation

Company B wants a predetermined rate for a new product that it will be launching soon. Its production department comes up with the details of how much the overheads will be and what other costs will be incurred. This video will discuss the differences between the traditional costing method and activity based costing. Since both average cost for bookkeeping service the numerator and denominator of the calculation are comprised of estimates, it is possible that the result will not bear much resemblance to the actual overhead rate. To keep this from being an issue, base the estimates on recent actual history, adjusted for your best estimate of production activity in the near future.

Predetermined Overhead Rate

If the job in work in process has recorded actual material costs of 4,640 for the accounting period then the predetermined overhead applied to the job is calculated as follows. A predetermined overhead rate is calculated before the start of an accounting period. Depending on the size of the business the predetermined overhead rate might be calculated for the whole business or, for a larger business, separate rates might be calculated for each department using a suitable basis. The allocation of overhead to the cost of the product is also recognized in a systematic and rational manner. The overhead is then applied to the cost of the product from the manufacturing overhead account.

•Predetermined rates make it possiblefor companies to estimate job costs sooner. Using a predeterminedrate, companies can assign overhead costs to production when theyassign direct materials and direct labor costs. Without apredetermined rate, companies do not know the costs of productionuntil the end of the month or even later when bills arrive. •Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive.

Predetermined Overhead Rate Basis

Again the actual overhead at the end of the accounting period is 1,575 and the overhead is said to be under applied by 81 (1,494 – 1,575) as shown below. If the actual overhead at the end of the accounting period is 1,575 the overhead is said to be under applied by 75 (1,500 – 1,575) as shown in the table below. The overhead is applied to the product units https://www.wave-accounting.net/ at the rate of 2.50 for each labor hour used. Companies need to make certain the sales price is higher than the prime costs and the overhead costs. In some industries, the company has no control over the costs it must pay, like tire disposal fees. To ensure that the company is profitable, an additional cost is added and the price is modified as necessary.

Figure 4.18 shows the monthly manufacturing actual overhead recorded by Dinosaur Vinyl. As explained previously, the overhead is allocated to the individual jobs at the predetermined overhead rate of $2.50 per direct labor dollar when the jobs are complete. High Challenge Company allocated manufacturing overhead costs to the two products for the month of January. Department A had estimated overhead of $2,000,000 and used 20,000 machine hours. If a job is in work in process and has recorded actual direct labor hours of 600 during an accounting period then the predetermined overhead applied to the job is calculated as follows.

Predetermined overhead rates

If at the beginning of the year the business estimates that manufacturing overheads will be 50,000 and that the estimated activity level will be 40,000 labor hours, then the pre-determined overhead rate is calculated as follows. Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important.

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. Ahead of discussing how to calculate predetermined overhead rate, let’s define it. A predetermined overhead rate(POHR) is the rate used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. If the business uses machine hours as the activity base and the estimated machine hours for the year is 5,000 then the machine hour rate calculation formula can be used as follows to calculate the predetermined overhead rate.

Establishing the overhead allocation rate first requires management to identify which expenses they consider manufacturing overhead and then to estimate the manufacturing overhead for the next year. Manufacturing overhead costs include all manufacturing costs except for direct materials and direct labor. Estimating overhead costs is difficult because many costs fluctuate significantly from when the overhead allocation rate is established to when its actual application occurs during the production process.

As a result, the overhead costs that will be incurred in the actual production process will differ from this estimate. The activity base (also known as the allocation base or activity driver) in the formula for predetermined overhead rate is often direct labor costs, direct labor hours, or machine hours. That is, a number of possible allocation bases such as direct labor hours, direct labor dollars, or machine hours can be used for the denominator of the predetermined overhead rate equation. The predetermined overhead rate is calculated by dividing the estimated manufacturing overhead by the estimated activity base (direct labor hours, direct labor dollars, or machine hours).

Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too. The predetermined overhead rate calculation shown in the example above is known as the single predetermined overhead rate or plant-wide overhead rate. The overhead will be allocated to the product units at the rate of 10.00 for each machine hour used. These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter. There are several concerns with using a predetermined overhead rate, which include are noted below.

Whereas, the activity base used for the predetermined overhead rate calculation is usually machine hours, direct labor hours, or direct labor costs. 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.