When companies begin the planning process of manufacturing a product, cost projections are a large and important focus. Calculating a predetermined overhead rate is one of the first tasks management will take on because it provides a formula to estimate the production costs of a product in advance. Specifically, the predetermined overhead rate is an approximated ratio of manufacturing overhead costs determined in advance based on variable and fixed costs.
The rate is configured by dividing the assumed overhead amount for a particular period by a certain activity base. For example, an activity base that is common in calculating the predetermined overhead rate is labor costs. If the estimated manufacturing overhead costs for an accounting period are assumed to be $200,000 and the direct labor cost is estimated at $150,000 the predetermined overhead rate would be 1.33. Therefore, every dollar of direct labor costs associated with production will cost $1.33 in overhead costs.
To gain a better understanding of this concept, it is important to understand the differences between operating expenses and overhead expenses. In general, management teams will divide expenses between these two categories because they provide broader insight into the true costs of production and manufacturing of a product. As more and more products are produced, the greater the effect on profitability. Dividing expenses by operating and overhead help to set prices accordingly and increase profit margins. Manufacturing operating expenses typically are comprised of machines, direct materials, labor hours and machine hours needed to manufacture a product. The cost of some of these items can vary based on the job or number of units produced and may require job-order costing or activity-based costing.
Overhead expenses are items that are required to sell products and run the company in general. Examples of overhead expenses are rent and utilities. The cost of these items is not dependent upon the number of units produced by the company. In other words, a company’s rent will not change if they produce 1000 units in a reporting period or if they don’t produce any units.
Using a predetermined overhead rate is advantageous to company planners because it helps them form strategies for the future. Using this calculation gives the best possible estimation of costs based on relatively comfortable overhead estimations. If a business uses an actual overhead cost, they would not be able to determine true costs until after the production has actually happened.
Another tremendous advantage for companies using the predetermined overhead rate is it provides a more consistent analysis even during periods of season variability. Costs to heat and cool a building will vary depending on the time of year, and it is possible that materials costs can increase or decrease during the year depending on the type of product being produced. The predetermined overhead rate takes these variations into consideration and offers a more dependable estimation.
Most companies will adopt the use of predetermined overhead rates in order to know how their products are performing even before the accounting period ends. It is a way to constantly evaluate the profitability of manufacturing instead of waiting until that reporting period comes to an end.