Definition
A predetermined overhead rate is an estimated rate that is used in the absorption of overheads in product costing. It’s calculated by dividing the estimated cost of overheads by the estimated/budgeted level of activity. It’s useful in cost accounting as product costing can only be obtained once overheads are absorbed in the cost of the product.
Detailed explanation
The business world is dynamic, and the production environment is getting complex day by day. The increasing complexity of the production function drives several indirect costs, and it’s becoming complex to deal with the same.
In simple words, complex manufacturing is not limited to the usage of direct material and direct labor, but the use of overheads has increased significantly. So, to absorb the indirect cost in the product cost predetermined overhead rate is determined. It’s important to note that actual overheads are not used in the calculation process. Instead, we use budgeted overheads. It’s because actual overheads vary from period to period based on seasonal variation and changes in the external environment. So, it’s wise to use budgeted overheads and forecasted levels of activity. The given formula is used to calculate the predetermined overhead rate.
Predetermined overhead rate = Budgeted overheads/budgeted level of activity
Overheads have been absorbed in the product cost traditionally using machine and labour hours. However, modern absorption requires the use of multiple bases to enhance the accuracy of the process. Further, the use of sophisticated techniques like the ABC costing system helps enhance the overall accuracy of the costing, quotation, and pricing. Hence, it leads to improvement in the business management system.
Example of predetermined overhead
Suppose the budgeted cost of overheads for the departmental store amounts to $20,000 per month, and the budgeted level of production is 10,000 per month. The predetermined rate of overheads can be calculated by putting the values in the above formula.
Pre-determined overhead rate = $20,000/10,000
Pre-determined overhead rate = $2
Advantage of using pre-determined overheads
Following are some of the advantages of using a predetermined overhead rate.
1-Seasonal variation is incorporated.
Predetermined overhead is estimated at the start of the accounting period. Hence, a suitable rate can be estimated based on the forecasted conditions of the accounting period.
2-Economies of scale are incorporated.
Budgeted level of activity and other details are used in the calculation of the overhead rate. So, if a higher activity level is forecasted in the accounting period, lower overheads can be estimated and vice versa. It leads to improvement in the overall process of costing.
Disadvantages of using predetermined overhead rate
Following are some of the disadvantages of using a predetermined overhead rate.
1-All inputs in the calculation are estimates.
Both inputs in the formula of overhead rate are estimated and not actual. Hence, there is a need to place more reliance on the estimated and not actual. So, there is a need to place more reliance on the management’s estimates, resulting in appropriate costing and reporting.
2-Variance calculation
The variance needs to be calculated between absorbed and actual overheads. If overheads absorbed are less than actual, adjusting entry to increase expense is posted in the accounting record and vice versa.
Conclusion
A predetermined overhead rate is used in the costing of the product. It’s calculated by obtaining budgeted cost and level of activity, and it’s preferred over actual overheads because estimates can include seasonal variations and other estimates.
Read full blog
