How to Calculate the Predetermined Overhead Rate

Calculate your predetermined overhead rate.

In order to make a profit when running a business, you will need to determine what fees to charge. This is true whether you are providing services or selling products. One of the ways to determine fees is to allocate overhead costs to each product or service, on top of the actual material and labor cost. You calculate overhead rates for each product or service that your company provides. Here's how you calculate the predetermined overhead rate.

Difficulty:

Moderately Challenging

Instructions

Things You'll Need

• Computer with spreadsheet software
• Adding machine
• Paper
• Pencil

Calculate Your Predetermined Overhead Rate

1. Gather all of your forecast expense and production data for the next 12-month period. If you are using actual expense and production information from the current year, you will need to make adjustments. Take into consideration increases or decreases in order quantities, new parts to be produced, wage increases and inflation on current expenses. The overhead rate includes all indirect expenses. Some examples are depreciation on buildings, equipment, taxes, insurance, advertising, administrative wages and anything else not directly related to production.

2. Segregate your forecast expenses by the type of product or service if your organization has several divisions or plants. For example, if inside one factory you have a molding plant, a paint plant, an assembly plant and an electronics plant, you should create separate overhead rates for each. If you have a small business--like a lawn-care operation or a pizza parlor--then one overhead rate is sufficient.

3. Total the indirect expenses applicable to each plant or service from the forecast 12-month budgets.

4. Calculate the production hours, machine capacity or man-hours for each process for which you would like to create an overhead allocation rate. Let's say you have a machine that cuts T-shirts. The machine can cut 100 shirts per hour. If you run one eight-hour shift a day, five days a week, you can make 208,000 T-shirts a year. This would be your total production hours for the year.

5. Divide the total indirect expenses by the total estimated production or service hours. Say your forecast total of indirect expenses for the next year is $416,000. You can make 208,000 T-shirts during that time. Therefore, because $416,000/208,000=$2, you would add $2 to the direct cost of each T-shirt to cover your overhead. Your overhead rate for the next 12-month period will be $2 per shirt. Therefore, if the material used per shirt is $1.50 and the direct labor per shirt is $2.25, your direct material and labor total $3.75. You would add your overhead of $2 for a total cost of $5.75 per shirt. If you want to make a profit, you must be able to sell each T-shirt for more than $5.75.

Tips & Warnings

• Calculate your current predetermined overhead rate based on actual data first. Your new rates should be similar, unless there is a drastic change in production, equipment or both.

• Some companies calculate five-year forecast and predetermined overhead rate to use on bids for future products to manufacture.

• If you are unfamiliar with industry norms, you should check rates for similar products. Otherwise, sales quotes based on your data may be way out of line. This will either cause the company to lose bids or get bids and lose money.

• Under-applying overhead to products or services could bankrupt your business.

Resources

• New York State Society of CPAs: Predetermined Overhead Rate