Predetermined Overhead Rate Definition, Example, Formula, and Calculation

On the other hand, the business with the machine incentive environment absorbs Bakery Accounting overhead based on the machine hours. However, the problem with absorption/traditional costing is that we have to ignore individual absorption bases and absorb all overheads using a single level of activity. Hence, this is a compromise on the accuracy of the overall allocation process. On the other hand, the ABC system is more complex and requires extensive administrative work. If the business used the traditional costing/absorption costing system, the total overheads amounting to $26,000 will be absorbed using labor hours. This is related to an activity rate which is a similar calculation used in activity-based costing.

Predetermined Overhead Rate (Definition, Example, Formula, and Calculation)

So, it’s advisable to use different absorption bases for the costing in terms of accuracy. It’s a completely estimated amount that changes with the change in the level of activity. However, if there is a difference in the total overheads absorbed in the cost card, the difference is accounted for in the financial statement. Complex overhead absorption is when multiple absorptions are required to allocate the cost of the support function. For instance, kitchen expenses first need to be allocated to the procurement department (a support department).

Divide budgeted overheads with the level of activity

The business has to incur different types of expenses for the manufacturing of the products. These expenses include a single predetermined overhead rate is called a(n) overhead rate direct material, direct labour, direct overheads, and indirect overheads etc. The direct cost is easily allocated in the product cost as we need to allocate the quantity in line with the usage.

Assess the level of activity

• Suppose following are the details regarding indirect expenses of the business.
• It’s also important to note that budgeted figures in calculating overhead rates are used due to seasonal fluctuation/expected changes in the external environment.
• So, the businesses need to do a cost-benefit analysis before implementing the ABC system of costing.
• For example, if we choose the labor hours to be the basis then we will multiply the rate by the direct labor hours in each task during the manufacturing process.
• At the end of the accounting period, the actual indirect cost is obtained and compared with the absorbed indirect.
• As a result, two identical jobs, one completed in the winter and one completed in the spring, would be assigned different manufacturing overhead costs.

In addition to this, project planning can also be done with the use of an overhead rate. It’s because it’s an estimated rate and can be predicted at the start of the project. Further, overhead estimation is useful in incorporating seasonal variation and estimate the cost at the start of the project. It’s important to note that if the business uses the ABC system, the individual activity is absorbed on a specific basis. For instance, cleaning and maintenance expenses will be absorbed on the basis of the square feet as shown in the table above.

So, the businesses need to do a cost-benefit analysis before implementing the ABC system of costing. Businesses normally face fluctuation in product demand due to seasonal variations. Fixed overheads are expected to increase/decrease per unit in line with the seasonal variations. So, the cost of a product in one period may not reflect the cost in another period—for instance, the cost of freezing fish increases in the summer and lowers in the winter.

• Implementation of ABC requires identification and record maintenance for various overheads.
• A predetermined overhead rate is used by businesses to absorb the indirect cost in the cost card of the business.
• For instance, it has been the traditional practice to absorb overheads based on a single base.
• For instance, in a labor-intensive environment, labor hours were used to absorb overheads.
• If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate.
• On the other hand, if the business wants to use actual overheads, it has to wait for the end of the month and get invoices in hand.

Income Statement Under Absorption Costing? (All You Need to Know)

For example, the cost of Job 2B47 at Yost Precision Machining would not be known until the end of the year, even though the job will be completed and shipped to the customer in March. For these reasons, most companies use predetermined overhead rates rather than actual overhead rates in their cost accounting systems. A predetermined overhead rate is used by businesses to absorb the indirect cost in the cost card of the business. Further, this rate is calculated by dividing budgeted overheads by the budgeted level of activity. Traditionally, overheads have been absorbed in the product cost based on a single basis of apportionment.

A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory. The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period. The second step is to estimate the total manufacturing cost at that level of activity. Common activity bases used in the calculation include direct labor costs, direct labor hours, or what are retained earnings machine hours. If an actual rate is computed monthly or quarterly, seasonal factors in overhead costs or in the activity base can produce fluctuations in the overhead rate.