How to Compute the Predetermined Overhead Rate for the Year Solution in Managerial Accounting
Companies calculate product or service costs by adding material, labor and overhead costs. Knowing the cost allows the company to set selling prices at a level that generates a profit. The company determines the material and labor costs by reviewing invoices and payroll reports. The company also needs to calculate a predetermined overhead rate, which allows the company to calculate the overhead cost for each product it manufactures. Businesses typically calculate and apply this rate at various points throughout the year.
Other People Are Reading
Instructions
-
Compute Predetermined Overhead Rate
-
1
Identify the overhead expenses from the annual budget. Overhead expenses vary from one company to the next and commonly include property taxes, facility rental expense or supervisor salary. Review each item in the budget report. Highlight items that qualify as manufacturing overhead. Manufacturing overhead refers to costs that the company incurs in the production facility, and is not considered materials or labor.
-
2
Add the total manufacturing overhead expenses identified in step 1. This total represents the total overhead base. The total overhead base needs to be allocated to the products or services the company expects to sell during the year.
-
-
3
Identify the estimated production units from the annual budget. During the budget preparation process, the production department determines its monthly production schedule. The monthly production schedule lists each product and the expected production quantity for the month. Add the monthly production quantities to calculate an annual production volume. For example, if the company expects to produce 100 units per month based on the production schedule, the total annual production equals 1,200 units.
-
4
Divide the total overhead expenses by the estimated production units. This provides the predetermined overhead rate per unit.
-
5
Record the predetermined overhead rate. The company uses this rate throughout the year to calculate inventory costs. Using the same cost maintains a consistent cost basis for the company and the integrity of the product costing system.
-
1
Tips & Warnings
Use the final budget report when calculating the predetermined overhead rate. Many companies revise the budget several times before finalizing each of the numbers. Preliminary budget reports contain numbers that may not reflect the final expectations of the company.
Remember that applying the overhead represents an allocation. No direct tie exists between the overhead cost and the product cost. The company needs to recognize this when making pricing decisions. If a customer proposes to place a special order at a reduced price, the company needs to consider the impact the overhead cost makes on that order and whether or not it should consider the overhead cost. Based on the original budget, the company expects to recoup all of its overhead costs through its scheduled production. A special order that recoups all of the material and labor costs and a portion of the overhead costs may present a good opportunity for the company.
