Question

In: Accounting

1. Why is a predetermined overhead rate useful in "applying" overhead costs in a manufacturing environment?...

1. Why is a predetermined overhead rate useful in "applying" overhead costs in a manufacturing environment? Can you think of any "downside" of using a predetermined overhead to apply/allocate overhead costs to jobs/departments?

http://en.wikipedia.org/wiki/Pre-determined_overhead_rate (Links to an external site.)

Expert Solution

The predetermined overhead rate is computed at the beginning of each period by dividing estimated total manufacturing overheads by the estimated volume of the allocation base, e.g. direct labor hours, machine hours, direct materials cost etc.

Example :

Estimated toral manufacturing overhead = $ 100,000.

Estimated direct labor hours = 10,000

Actual direct labor hours = 11,000

Actual overheads incurred = $ 112,000

Predetermined overhead rate = $ 100,000 / 10,000 = $ 10 per DLH

Applied overhead = 11,000 x $ 10 = $ 110,000

Overheads underapplied = $ 112,000 - $ 110,000 = $ 2,000.

Downsides to using a predetermined overhead rate :

a. Not very suitable for service industries.

b. Selecting the most suitable allocation base or cost driver may be difficult.

c. Estimations of manufacturing overheads may be unrealistic.

d. Estimation of the volume of cost driver consumed may also be inaccurate.

e. Distorted cost information can lead to erroneous pricing decisions.

ekkarill92 answered 2 years ago

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