Predetermined overhead rates are a crucial tool in managerial accounting. They allow companies to estimate and apply overhead costs to products before the actual costs are known, enabling timely decision-making and consistent cost reporting throughout the period.

The process involves calculating a rate based on estimated costs and activity levels, then applying it to actual production. This method smooths out cost fluctuations, simplifies overhead allocation, and facilitates cost analysis and pricing decisions.

Predetermined Overhead Rates and Application

Predetermined overhead rate calculation

• Estimates total overhead costs and activity base before the period begins
  • Enables timely reporting and decision making throughout the period
  • Evens out overhead cost fluctuations (seasonal variations, production volume changes)
• Predetermined overhead rate formula: $\frac{\text{Estimated total overhead costs}}{\text{Estimated total units in the allocation base}}$
  • Allocation base measures activity driving overhead costs (direct labor hours, machine hours, units produced)
  • Determines overhead cost per unit of activity (rate per direct labor hour, rate per machine hour)
• Calculating predetermined rate example:
  • Estimated overhead costs: $100,000
  • Estimated direct labor hours: 5,000
  • Predetermined rate: $20 per direct labor hour ($100,000 / 5,000 hours)

Overhead application to production

• Applies overhead costs to products or services using predetermined rate and actual activity level
  • Assigns a portion of overhead costs to each unit produced
  • Calculates total production cost (direct materials + direct labor + applied overhead)
• Applied overhead formula: $\text{Predetermined overhead rate} \times \text{Actual activity level}$
  • Multiplies predetermined rate by actual activity consumed (actual direct labor hours worked, actual machine hours used)
• Applying overhead example:
  • Predetermined rate: $20 per direct labor hour
  • Actual direct labor hours: 4,800
  • Applied overhead: $96,000 ($20 × 4,800 hours)
  • Adds $96,000 to total production cost for the period

Rationale for predetermined rates

• Actual overhead costs unknown until period ends
  • Using actual costs delays reporting and decision making
  • Hinders timely cost control and variance analysis
• Predetermined rates enable timely reporting and management
  • Allows comparing applied overhead to actual overhead costs throughout period
  • Identifies variances for investigation (over-applied overhead or under-applied overhead)
• Smooths overhead cost fluctuations over time
  • Provides more consistent unit costs (avoids extreme high or low costs due to volume changes)
  • Aids in pricing and budgeting decisions
• Simplifies overhead cost allocation to products or jobs
  • Avoids tracking actual overhead costs consumed by each product (time-consuming, complex)
  • Applies overhead based on readily available activity measures (direct labor hours, machine hours)
• Facilitates cost-volume-profit analysis by providing consistent overhead costs

Costing Methods

• Normal costing: Uses predetermined overhead rates and actual direct costs
• Actual costing: Uses actual overhead and direct costs, but delays reporting
• Activity-based costing: Assigns overhead based on multiple cost drivers for more accurate product costing