A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year.
The predetermined rate is derived using the following calculation:
Estimated amount of manufacturing overhead to be incurred in the period ÷ Estimated allocation base for the period
A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours.
For example, the controller of the Gertrude Radio Company wants to develop a predetermined overhead rate, which she can use to apply overhead more quickly in each reporting period, thereby allowing for a faster closing process. For this calculation, she uses the average manufacturing overhead cost for the past three months, and divides by the estimated amount of machine hours to be used in the current month, based on the most recent production schedule for the period. This results in $50,000 being allocated to inventory in the period. A later analysis reveals that the actual amount that should have been assigned to inventory is $48,000, so the $2,000 difference is charged to the cost of goods sold.
There are several concerns with using a predetermined overhead rate, which include:
- Not realistic. Since both 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.
- Decision basis. If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions.
- Variance recognition. The difference between the actual and predetermined amounts of overhead could be charged to expense in the current period, which may create a material change in the amount of profit and inventory asset reported.
- Weak link to historical costs. The use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or decline in these costs.
Larger organizations may employ a different predetermined overhead rate in each production department, which tends to improve the accuracy of overhead application by employing a higher level of precision.