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Predetermined Overhead Rate Formula

Updated on April 5, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

Formula to Calculate Predetermined Overhead Rate

A Predetermined Overhead ratePredetermined Overhead RatePredetermined overhead rate is the distribution of expected manufacturing cost to the presumed units of machine-hours, direct labour hours, direct material, etc., for acquiring the per-unit expense before every accounting period.read more shall be used to calculate an estimate on the projects that are yet to commence for overhead costs. It would involve calculating a known cost (like Labor cost) and then applying an overhead rate (which was predetermined) to this to project an unknown cost (which is the overhead amount). The formula for calculating Predetermined Overhead Rate is represented as follows.

Predetermined Overhead Rate = Estimated Manufacturing O/H Cost / Estimated total Base Units
Predetermined-Overhead-Rate-Formula

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For eg:
Source: Predetermined Overhead Rate Formula (wallstreetmojo.com)

Where,

  • O/H is overhead
  • Total base units could be the number of units or labor hours etc.

Predetermined Overhead Rate Calculation (Step by Step)

The predetermined overhead rate equation can be calculated using the below steps:

  1. Gather total overhead variables and the total amount spent on the same.

  2. Find out a relationship of cost with the allocation base, which could be labor hours or units, and further, it should be continuous.

  3. Determine one allocation base for the department in question.

  4. Now take a total of overhead cost and then divide the same by the allocation base determined in step 3.

  5. The rate computed in step 4 can also be applied to other products or departments.

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Examples

Example #1

Suppose that X limited produces a product X and uses labor hours to assign the manufacturing overhead cost. The estimated manufacturing overhead was $155,000, and the estimated labor hours involved were 1,200 hours. You are required to compute a predetermined overhead rate.

Solution

Here the labor hours will be base units.

Use the following data for the calculation of a predetermined overhead rate.

  • Manufacturing O/H Cost: 150000
  • Labor hours (Total Base Unit): 1200

Calculation of the predetermined overhead rate can be done as follows:

Predetermined Overhead Rate Formula Example 1.1png

=150000/1200

The predetermined Overhead Rate will be –

Predetermined Overhead Rate Formula Example 1.2png

Predetermined Overhead Rate = 125 per direct labor hour

Example #2

Gambier is head of TVS Inc. He is considering the launch of the new product, VXM. However, he wants to consider the pricing for the same. Therefore, he has asked the production head to develop the details of costing based on existing product overhead costs to apply the same to product VXM while making its pricing decisions. The details from the production department are as follows:

ParticularUnitsAmount
Direct LaborBased on labor hours235000
Direct MaterialBased on the number of units350000
Variable OverheadBased on labor hours145000
Fixed OverheadBased on labor hours420000
Direct Labor Hours8500

The production head wants to calculate a predetermined overhead rate, as that is the main cost allocated to the new product VXM. Therefore, you are required to calculate the predetermined overhead rate.

As the production head wants to calculate the predetermined overhead rate, all the direct costs will be ignored, whether direct costDirect CostDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more (labor or material).

Solution

Calculation of Total Manufacturing Overhead 

Predetermined Overhead Rate Formula Example 2.1png

The total manufacturing overheadManufacturing OverheadManufacturing Overhead is the total of all the indirect costs involved in manufacturing a product like Property Tax on the production premise, Remunerations of maintenance personnel, Rent of the manufacturing building, etc. read more cost will be variable overhead, and fixed overhead, which is the sum of 145,000 + 420,000 equals 565,000 total manufacturing overhead.

=145000+420000

Total Manufacturing Overhead = 565000

Here the labor hours will be base units

Calculation of the predetermined overhead rate can be done as follows:

Example 2.2png

=565000/8500

The predetermined Overhead Rate will be –

Example 2.3png

= 66.47 per direct labor hour

Hence, this predetermined overhead rate of 66.47 shall be applied to the pricing of the new product VXM.

Example #3

Company X and Company Y are competing to acquire a massive order as that will make them much recognized in the market, and also, the project is lucrative for both of them. After going to its terms and conditions of the bidding, it stated the bid would be based on the overhead rate percentage. Therefore, the one with the lower shall be awarded the auction winner since this project would involve more overheads. Both of the companies have reported the following overheads.

ParticularCompany ACompany B
Factory Rent3500038500
Factory Manager Salary120000115000
Utilities of Factory155670145678
Electricity Bill4500951340
Quality Assurance Department345600351750
Labour Hours per Unit2 hrs1.5 hrs
Number of Units Produced20002500

You must calculate the predetermined overhead rate based on the above information and determine the chances of which company is more?

Solution:

We shall first calculate the total manufacturing overhead cost for Company A

Predetermined Overhead Rate Formula Example 3.1png

=35000+120000+155670+45009+345600

  • Total Manufacturing Overheads = 701279

Total Labor Hours will be –

Predetermined Overhead Rate Formula Example 3.2png

=2000*2

  • Total Labor Hours =4000

Calculation of Predetermined Overhead Rate for Company A is as follows

Example 3.3png

=701279/4000

The predetermined Overhead Rate for Company A will be –

Predetermined Overhead Rate Formula Example 3.4png

Predetermined Overhead Rate = 175.32

We shall first calculate the total manufacturing overhead cost for Company B

Predetermined Overhead Rate Formula Example 3.5png

=38500 + 115000 + 145678 + 51340 + 351750

  • Total Manufacturing Overheads = 702268

Total Labor Hours will be –

Predetermined Overhead Rate Formula Example 3.6png

=2500*1.5

  • Total Labor Hours =3750

Calculation of Predetermined Overhead Rate for Company B is as follows

Example 3.7png

=702268/3750

The predetermined Overhead Rate for Company B will be –

Example 3.8png

Predetermined Overhead Rate = 187.27

Hence, preliminary, company A could be the winner of the auction even though the labor hour used by company B is less, and units produced more only because its overhead rate is more than that of company A.

Relevance and Uses

Commonly, the manufacturing overhead cost for machine hours can be ascertained from the predetermined overhead rate in the manufacturing industry. However, in the case of machine production, this rate can be used to identify the expected costs, which shall allow the firm to allocate their financial resources properly, which are needed to ensure the efficient and proper working of operations and production. Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals.

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