A predetermined overhead rate is a cost of doing business that includes costs of the fixed assets, such as property or buildings, used in manufacturing. At the beginning of the accounting period, a predetermined overhead rate is determined by dividing the predicted manufacturing overhead by the anticipated activity base.
The predetermined overhead rate plays an important role in every business because it helps determine the price the company will sell its products to make a profit. To understand the predetermined overhead rate concept you have to invoke some accounting principles that you learnt in the course of your career.
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Basis of Predetermined Overhead Rate
As a fund accounting beginner, understanding the basis of the predetermined overhead rate may seem challenging but we have simplified it for you.
Predetermined overhead rate takes into account the fixed assets used in the business. Fixed costs are used to determine how much of a firm’s total expenses can be allocated to its products.
This rate determines how much of a product’s cost is attributable to production and how much is attributable to non-production related activities, such as administrative and sales expenses. It may include costs such as rent, depreciation, insurance, security, utilities, and maintenance. The predetermined overhead rate may also vary by product.
Importance of Predetermined Overhead Rate
To gain a better understanding of the importance of the predetermined overhead rate its important to familiarize yourself with the importance of accounting to a business or organization. The following are reasons why you should consider applying the predetermined overhead concept to your business or organization.
1. Determine a Company’s Estimated Taxable Income
The predetermined overhead rate is used to calculate taxable income. Sometimes, a company may need to make certain deductions that are not directly involved in producing a good or service, such as administrative salaries and sales commissions.
These costs must be accounted for separately. Calculating the predetermined overhead rate will allow the company to determine its estimated taxable income by factoring in all expenses associated with manufacturing products.
2. Identify Areas for Cost Reduction
A company’s overhead costs are considered a necessary expense, so it is important to accurately track these numbers. If the predetermined overhead rate for a company is higher than its competitors, then the company should consider methods for reducing costs.
This may include job cuts or outsourcing some services. If the predetermined overhead rate is lower than its competitors, then the company needs to consider ways to improve efficiency to avoid loss of business.
3. Use the Estimate to Set Target Prices
With its predetermined overhead rate and estimated taxable income, a company can calculate a target price that it can use in setting prices for different products or services.
These numbers are used to determine the cost of production and overhead expenses, which is necessary to make price decisions. By knowing these costs, a company will be able to set an appropriate price for each product or service.
4. Compare Predetermined Overhead Rate to Industry Average
To make sure its pricing is competitive, it may want to compare its predetermined overhead rate to the same information for other companies in the same industry. By comparing these numbers, a company can ensure that it is still cost-efficient while trying to attract new customers.
5. Determine Profit Percentage
A company cannot set target prices without knowing its cost of production. It needs to know the separate costs involved in producing a good or service as well as the fixed assets used in doing so. The predetermined overhead rate reveals the fixed assets used in producing a product, so it is necessary for determining accurate pricing.
Uses of Predetermined Overhead Rate
You can use the predetermined overate in the ways mentioned below. However, you should always take note of the ethical requirements in accounts to ensure that you don’t misuse financial information.
1. Determine Net Income
The predetermined overhead rate is used to find a company’s net income by subtracting total expenses from total income. The predetermined overhead rate can be calculated for an entire period or it can be calculated per product sold.
2. Compare Product Profitability
A company may have several products that have different predetermined overhead rates, depending on the fixed assets used in producing them. By calculating each product’s predetermined overhead rate, the company can make decisions on target prices and its price competitiveness.
3. Determine Pricing
A company cannot set target prices without knowing its cost of production. It needs to know the separate costs involved in producing a good or service as well as the fixed assets used in doing so. The predetermined overhead rate reveals the fixed assets used in producing a product, so it is necessary for determining accurate pricing.
4. Assess Capital Spending Needs
The predetermined overhead rate is a useful tool for analyzing capital needs. By factoring in the fixed costs associated with fixed assets, the amount of money needed for new equipment can be determined. In addition to calculating capital needs, the predetermined overhead rate is a useful tool for determining the rate of depreciation or amortization expenses.
Elements Involved in Computing a Predetermined Overhead Rate
Every business should use the generally accepted accounting principles of accounting when calculating the predetermined overhead rate. That’s why it is important to know the elements involved in this concept. Some of the things you should take note of include:
1. Take into Account Depreciation Expense and Equipment
The fixed assets used in manufacturing, such as buildings, machinery, or equipment, may have to be depreciated over time. By taking into account these fixed assets with the predetermined overhead rate, it is possible to calculate depreciation costs.
For example, a building will have a predetermined overhead rate which equals the depreciation expense multiplied by the useful life of the building.
2. Consider Rent Expenses and Utilities
Rent expenses can be factored into a company’s predetermined overhead rate. Utilities, such as heat and electricity, should also be taken into account with a predetermined overhead rate.
3. Calculate Insurance Expenses
Insurance costs should be a part of the predetermined overhead rate. It is important to include these expenses when evaluating a company’s profitability and assessing whether it has adequate resources to grow its business.
How to calculate predetermined overhead rate
At the beginning of the accounting period, a predetermined overhead rate is determined by dividing the predicted manufacturing overhead by the anticipated activity base.
Example 1
Based on annual machine hours, Beka Baking Company calculated a predetermined overhead rate.
The Beka Baking Company forecasted that the year’s total production overhead expenses would be $320,000 and that machine hours would reach 50,000 at the beginning of 2021.
The company’s actual manufacturing overhead expenditures for the entire year came to $300,000, and the number of machine hours used was 53,000.
Calculate the anticipated overhead rate for 2021 now.
Answer
Predetermined overhead rate = Estimated Manufacturing Overhead Cost/ Estimated Machine hours
$320,000/50,000 hours = $6.40 for every machine hour.
Manufacturing overhead applied to products = Actual machine use hours x predetermined overhead rate
53,000 * $6.40 = $339,200
Example 2
NewFace clothline Company calculates its predetermined overhead rate on the basis of annual direct labor hours. At the start of year 2019, the company estimated that its total manufacturing overhead cost would be $300,000 and the total direct labor cost would be 45,000 hours. The actual total manufacturing overhead incurred for the year was $280,000 and actual direct labor hours worked during the year were 48,000.
To Do;
- Calculate NewFace predetermined overhead rate for the year 2019.
- Find the amount of manufacturing overhead cost that NewFace would have applied to its units of product.
Solution
1. Predetermined overhead rate:
Predetermined overhead rate = Estimated manufacturing overhead/Estimated direct labor hours
= $300,000/45,000 hours
= $6.7 per direct labor hours
2. Manufacturing overhead applied to products:
Manufacturing overhead cost = Actual direct labor hours worked x Predetermined overhead rate
= 48,000 hours x $6.7
= $321,600
Problems With Predetermined Overhead Rates
Despite the many advantages that come with calculating the predetermined overhead rate, it also has a set of drawbacks. They include:
1. The Notion is Incorrect
The notion that profit margins are based on predetermined overhead rates is incorrect. It does not take into account the fixed assets used in production, which for manufacturing companies can be significant.
2. Difficult to Calculate
Calculating a company’s total expenses and a set amount of income is an estimate based on past spending habits. If a company is too risky, then its predetermined overhead rate may be higher than other firms’. This means that it will experience a higher risk of bankruptcy, which has the potential to damage its brand.
3. Overly Conservative
A company may be overly conservative, which can hurt its bottom line. This means that it is set up to lose money at the expense of future growth and revenue growth.
4. Difficult to Adjust
A company’s predetermined overhead rate is based on fixed expenses, so adjustments in these costs may not be able to be made quickly or easily. For example, if a company has a large number of employees, then adjusting these costs may be difficult.
5. Often Incorrect
There is often an assumption that the predetermined overhead rate will always be accurate. If a company’s predetermined overhead rate is too low, then it is likely that the company will become inefficient and eventually go out of business. However, if it has too high a rate, it may be unnecessary to risk its future profitability by lowering its target prices.
The manufacturing process of each company must meet the global standards in order to continue carrying out its operations. Predetermined overhead rates are important for each company for it helps access the company’s performances by tracking expenses and resource utilization in every department. If you are looking for accurancy when calculating the predetermined overhead rate of any company, consider seeking help of a professional tutor.
More Resources
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