The predetermined overhead rate is based on the anticipated amount of overhead and the anticipated quantum or value of the base. It is worked out by dividing the estimated amount of overhead by the estimated value of the base before actual production commences. It is applied for the absorption of overheads during the period for which they have been computed. Predetermined overhead rates are not static, and businesses can adjust the rate, based on unforeseen overhead fluctuations. The flexibility in this model allows for responsiveness to major changes in the overhead structure. Using a predetermined rate on short, time-period cycles, makes fluctuation adjustments an easy accounting process.

As such, the actual overhead rate is useless from the point of view of cost control. Utility bills, raw materials, labor, employees, equipment and everything that factors into the production of a product will enter the predetermined overhead rate calculation. Historic overhead rates are useful for analyzing consistent https://www.bookstime.com/ expenses and expenses that spike seasonally. After weighing the total costs for the period against the resulting supply, the predetermined rate is reached on a per-unit basis. Management analyzes the costs and selects the activity as the estimated activity base because it drives the overhead costs of the unit.

1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number. As you’ve learned, understanding the cost needed to manufacture a product is critical to making many management decisions (Figure 6.2). Knowing the total and component costs of the product is necessary for price setting and for measuring the efficiency and effectiveness of the organization. Remember that product costs consist of direct materials, direct labor, and manufacturing overhead.

Establishing a predetermined overhead rate for your business can give you a tool to help keep expenses in proportion with sales and production volumes. Monitoring a well-defined rate provides a quick signal that lets you know when it’s time to review spending and, in doing so, will help you protect your profit margins. Overhead expenses are generally fixed costs, meaning they’re predetermined overhead rate formula incurred whether or not a factory produces a single item or a retail store sells a single product. Fixed costs would include building or office space rent, utilities, insurance, supplies, maintenance, and repair. Unless a cost can be directly attributable to a specific revenue-generating product or service, it will be classified as overhead, or as an indirect expense.