Question

Explain what a predetermined overhead rate is, how it is calculated, and why it is used.

Answer 1

Predetermined Overhaed rate is a rate which is used to allocate the various overhead cost to a product, service, department, etc on the basis of allocation base. Overhead Cost basically include cost like rent, depreciation, indirect material & labour cost, etc.. Allocation Base can be machine hours, direct labour hours.

So. Predetermined Overhead rate = Estimated Overhead Cost / Estimated Allocation Base

Suppose, Production department of XYZ company has estimated the following overhead cost

Rent of Factory - 60000, Depreciation on Machine - 100000, Indirect Labour & Material Cost - 40000

So, total Overhead Cost = 60000+100000+40000= 200000

Let us assume it uses more machines than labour and it has estimated that machine will run for 50000 Hrs

So Predetermined Rate = Overhead Cost/ Machine Hours

= 200000/50000

= 4 per Machine Hour

Predetermined Overhead Rate has many advantages

- In the above example, predetermined overhead rate is 4 per machine hrs, the rate can be applied to determine the cost of a product and hence can decide its sales value. For example, to produce a product X, 4 machine hrs are required and its direct cost is $ 25. So, its cost of production = 25+(4*5) = 45, and by adding $ 5 as a profit margin, it can be sold $ 50.

- Predetermined rate can be used to compare the predetermined cost with its actual cost and can analyse the reason for variance. For example, during a month machines was used for 5000 hrs, so its predertermined cost is 5000*4 = $ 20000, but actual overhead cost incurred is 25000, so in this case company can use the predetermined rate to find out the variance and analyse it.

- Calculation of profit. Companies profit can be calculated using the predetermined rate instead of waiting for the actual overhead to occur till the end of the year.

- Different predetermined rate can be used for different departments for control purpose. For example, manufacturing overhead can be control using machine hrs, Sales Department overhead cost can be checked on the basis of product sold, etc. So it can be used for control purpose for various departments within an organisation.