What Is Predetermined Overhead Rate?
Predetermined overhead rate is a key concept in accounting used to calculate the cost of production. It’s a way to determine the amount of overhead, or indirect costs, associated with producing an item. This method can be useful for businesses that need to accurately price their products and services. In this article, we will cover what predetermined overhead rate is, why it’s important for businesses, and how it can be calculated. We’ll also look at some examples of its use in production pricing.
What is Predetermined Overhead Rate?
As its name suggests, a predetermined overhead rate is an estimate of the overhead costs that will be incurred by a company during a specific period of time. This rate is used to allocate these costs to the various products and services that the company produces. The goal is to have a more accurate understanding of the true cost of each product or service.
There are a number of factors that go into calculating a predetermined overhead rate. These include the estimated amount of overhead costs for the period, as well as an estimation of the amount of production during that same period. This information is then used to calculate an overhead rate per unit of production.
Once calculated, this rate can be applied to future periods in order to predict and better understand the financial impact of overhead costs. It can also be used retroactively, to help assess the cost effectiveness of past productions. In either case, having a clear understanding of your company’s predetermined overhead rate can be helpful in making key decisions about pricing, production levels, and more.
How to Calculate Predetermined Overhead Rate?
To calculate your predetermined overhead rate, you’ll need to know three things: your estimated annual overhead costs, your expected production volume for the year, and your desired profit margin.
Once you have these numbers, you can use the following formula:
Predetermined Overhead Rate = Estimated Annual Overhead Costs / (Expected Production Volume * Desired Profit Margin)
For example, let’s say your estimated annual overhead costs are $100,000, your expected production volume for the year is 10,000 units, and your desired profit margin is 10%. In this case, your predetermined overhead rate would be $10 per unit. ($100,000 / (10,000 * 10%))
Keep in mind that your predetermined overhead rate is just an estimate – it’s not set in stone. As your business grows and changes, you may need to adjust your rate accordingly.
Advantages of Predetermined Overhead Rate
There are several advantages to using a predetermined overhead rate rather than actual overhead costs when assigning costs to products or services. First, it is more accurate than using a company-wide overhead percentage because it takes into account the specific types of overhead costs associated with the production process. Second, it is less likely to under- or over-recover fixed costs, which can lead to distorted product prices. Finally, using a predetermined overhead rate simplifies the allocation of overhead costs and makes budgeting and forecasting easier.
Disadvantages of Predetermined Overhead Rate
There are a few disadvantages of predetermined overhead rates to be aware of. First, these rates can be complex to calculate, which can lead to errors. Second, if the underlying assumptions change (e.g., the expected level of activity), the rates will no longer be accurate and will need to be recalculated. Finally, predetermined overhead rates can be difficult to update on a regular basis, which can lead to outdated information being used in decision-making.
Predetermined overhead rate can be a useful tool for businesses that need to accurately budget their production costs. It involves estimating the total cost of producing goods and services, then dividing it by either direct labor hours or machine hours used in production. Knowing your predetermined overhead rate helps you plan and control future expenditures effectively, improving efficiency and profitability for your business. With this information in mind, it pays to take some time to calculate your own predetermined overhead rate so that you can manage expenses with confidence.