Predetermined Overhead Rate DefinitionA company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data. Show
Predetermined Overhead Rate ExampleFor example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and
direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in
underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the
overhead costs are applied to each unit of production output. Predetermined Overhead Rate UsageTraditional costing systems apply indirect costs to products based on a predetermined
overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing
the predetermined overhead rate in the traditional costing process, including the following: Calculating Predetermined Overhead RateFirst, use the following formula to calculate overhead rate.  [box]Strategic CFO Lab Member Extra Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits. Click here to access your Execution Plan. Not a Lab Member? Click here to learn more about SCFO Labs[/box] A predetermined overhead rate sets the manufacturing overhead cost of a work in process. The rate is determined before production even begins, meaning that it is not necessarily an accurate representation of the actual cost of overhead for a project. Nevertheless, many managers prefer to use a predetermined overhead rate because of advantages in the way of consistency. Components of Predetermined Overhead RateThe predetermined overhead rate is based on the estimated total overhead costs to the estimated total activity base. The overhead costs include items such as electricity, administrative salaries and wages, rent and other costs applied to the business as a whole. The activity base refers to costs associated with the actual project, such as the labor cost of employees directly engaged in the project and raw materials. Calculation of Predetermined Overhead RateThe predetermined overhead rate is calculated by simply dividing the estimated overhead expense by the estimated activity base. For example, if overhead expenses are estimated to be $5 million for a particular period and the activity cost of a manufacturing project over that period amounts to $20 million, the predetermined overhead rate would be 1-to-4, meaning that for every dollar spent on the direct costs of a project, management should allocate 25 cents in overhead costs. Seasonal VariationThe primary advantage of a predetermined overhead rate is to smooth out seasonal variations in overhead costs. These variations are to a large extent caused by heating and cooling costs, which, while high in the summer and winter months, are relatively low in the spring and fall. The actual cost of a particular project, however, should be evaluated independently of the season in which the project is completed. Project PlanningAnother advantage of a predetermined overhead rate is that it can be used to plan for the cost of future projects. If a company wants to use the actual overhead rate to calculate the cost of a project, it is unable to do so until after the project has been completed and true costs are known. Estimating the cost relative to the activity base allows managers to budget for future projects. Why is the predetermined overhead rate important?Monitoring relative expenses: Predetermined overhead rate provides companies with a percentage they can monitor on a quarterly, monthly and even weekly basis, with the amount of base and expense being proportionate to each other. This can help you ensure costs aren't escalating.
Why do companies use predetermined overhead rates rather than actual manufacturing overhead?Why do companies use predetermined overhead rates rather than actual manufacturing overhead costs to apply overhead to jobs? if actual manufacturing over head cost is applied to jobs, the company must wait until the end of the accounting period to apply overhead and to cost jobs.
Why must a company use predetermined overhead rates when using job order costing?However, predetermined overhead rates allow production managers to allocate overhead expenses as soon as production begins. Having this information when production begins allows managers to make better cost-based business decisions. These include cost-control assessments as well as pricing and budgeting decisions.
What is the purpose for using predetermined overhead rates quizlet?Manufacturing overhead costs are assigned to jobs using a predetermined overhead rate. The rate is determined at the beginning of the period so that jobs can be costed throughout the period rather than waiting until the end of the period.
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