Predetermined overhead cost rates are calculated estimates used to allocate overhead costs to products or services based on a chosen cost driver, such as labor hours, machine hours, or production volume. These rates are established before the production period begins and are based on estimated overhead costs and expected activity levels.
By using predetermined overhead cost rates, businesses can ensure timely cost allocation during production, as the rates provide a consistent and systematic way to distribute overhead costs to individual products or services. This method helps in maintaining accurate and up-to-date cost information, which is essential for setting product prices, controlling costs, and analyzing profitability.
Moreover, predetermined overhead cost rates enhance budgetary control and financial planning by providing a clear framework for managing overhead expenses. They enable businesses to compare actual overhead costs with the estimated rates, identify variances, and take corrective actions if necessary. This proactive approach to overhead cost management supports better decision-making and resource allocation, ultimately contributing to the overall financial health and efficiency of the business.
In summary, predetermined overhead cost rates are a valuable tool in cost accounting that ensures accurate and timely allocation of overhead costs, enhances budgetary control, and supports effective financial planning.
1. What Are Predetermined Overhead Cost Rates?
A predetermined overhead cost rate is an estimated rate used to apply overhead costs to products during the accounting period, calculated before actual costs are known.
A. Key Features
- Estimated Calculation: Determined at the beginning of the period based on budgeted costs.
- Cost Driver Usage: Allocates costs based on labor hours, machine hours, or other activity bases.
- Timely Application: Enables overhead allocation throughout the period without waiting for actual costs.
B. Importance of Predetermined Overhead Rates
- Budget Control: Helps in planning and controlling costs during the period.
- Product Costing: Provides accurate cost information for pricing decisions.
- Financial Reporting: Ensures timely preparation of financial statements.
2. Calculation of Predetermined Overhead Rates
Calculating predetermined overhead rates involves estimating total overhead costs and selecting an appropriate allocation base.
A. Formula
- Predetermined Overhead Rate = Budgeted Overheads ÷ Budgeted Activity Base.
B. Example
- Budgeted Overheads: $500,000.
- Budgeted Direct Labour Hours: 100,000 hours.
- Predetermined Overhead Rate: $500,000 ÷ 100,000 = $5 per labor hour.
3. Methods of Applying Predetermined Overhead Rates
Different methods are used to apply predetermined overhead rates based on the chosen cost driver.
A. Direct Labour Hour Method
- Definition: Applies overhead based on direct labor hours.
- Example: $5 per labor hour applied to each product’s labor hours.
B. Machine Hour Method
- Definition: Applies overhead based on machine hours.
- Example: $4 per machine hour applied to each product’s machine usage.
C. Percentage of Direct Labour Cost
- Definition: Applies overhead as a percentage of direct labor costs.
- Example: 20% of direct labor cost allocated as overhead.
D. Percentage of Direct Material Cost
- Definition: Applies overhead as a percentage of direct material costs.
- Example: 15% of direct material cost allocated as overhead.
4. Steps in Using Predetermined Overhead Rates
Implementing predetermined overhead rates involves key steps for accurate cost allocation.
A. Estimate Total Overheads
- Step: Identify and estimate all overhead costs for the period.
B. Select Allocation Base
- Step: Choose an appropriate base (e.g., labor hours, machine hours).
C. Calculate Overhead Rate
- Step: Divide estimated overhead by the total budgeted base.
D. Apply Overheads During Production
- Step: Multiply the overhead rate by actual usage during production.
5. Tools for Managing Predetermined Overhead Rates
Various tools help in calculating and applying predetermined overhead rates effectively.
A. Microsoft Excel
- Use: Performs calculations and maintains overhead records.
B. Cost Accounting Software
- Use: Automates overhead rate application using tools like SAP and QuickBooks.
6. Applications of Predetermined Overhead Rates
Predetermined overhead rates are applied in various financial and operational areas.
A. Product Costing
- Application: Ensures all overheads are included in product costs.
B. Budgeting
- Application: Helps prepare accurate budgets by estimating overheads.
C. Financial Reporting
- Application: Provides timely and accurate financial reports.
7. Advantages of Predetermined Overhead Rates
Using predetermined overhead rates offers numerous benefits to businesses.
A. Timely Cost Allocation
- Advantage: Allocates costs during production without waiting for actual costs.
B. Budget Control
- Advantage: Enhances budgetary control and cost management.
C. Accurate Product Pricing
- Advantage: Ensures prices reflect all incurred costs.
8. Limitations of Predetermined Overhead Rates
Despite its benefits, predetermined overhead rates have limitations.
A. Inaccurate Estimates
- Limitation: Budgeted overheads may differ from actual costs.
B. Changes in Activity Levels
- Limitation: Variations in production levels affect cost accuracy.
C. Single Base Limitation
- Limitation: Using one cost driver may not reflect all cost behaviors accurately.
9. The Role of Predetermined Overhead Rates in Cost Accounting
Predetermined overhead cost rates are essential for timely cost allocation, budgeting, and financial reporting. While they provide several benefits, such as accurate product costing and budget control, businesses must regularly review and adjust these rates to ensure they reflect actual cost behaviors and maintain financial accuracy.