Cost Accounting to Calculate Predetermined Factory Overhead Rate
While assigning a materials cost or cost of labor to products can be as easy as observing how much flour goes into a cookie or how long a machinist works on an airplane, overhead costs present challenges due to the intangible nature of the cost. A common method of overhead cost allocation is the use of a factory predetermined overhead rate. This method allows cost accountants to estimate how much overhead should be assigned to each product.
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Allocation Base
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The first step in calculating a predetermined factory overhead rate is the identification of an allocation base. The allocation base is the activity that drives the application of overhead costs to products. For example, if a cost accountant determines that the use of machinery is what causes increases and decreases in overhead costs, then machine hours may be an effective allocation base. It is important to note that no allocation base is perfect; managerial accountants should be cautioned to balance effectiveness and efficiency when determining the allocation base to be used for calculation of the factory rate.
Overhead Budget
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To apply costs to products, an estimate of costs must be calculated. Because the predetermined overhead rate is used throughout the year to estimate costs of production and annual overhead costs are not determined until the end of the year, estimation techniques must be used. Common strategies include estimating overhead as a percentage of sales, using prior-year overhead amounts and adjusting these amounts for changes in forecasts, and using statistical estimation techniques.
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Calculate the Rate
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To calculate the predetermined overhead rate, the total estimated overhead is divided by an estimate of the allocation base level of activity. For example, if cost accounting has estimated a total overhead cost of $450,000 for next year, the allocation base was determined to be direct labor hours, and the forecast direct labor hour usage was $900,000, the the predetermined factory overhead rate would $450,000 divided by $900,000, or $0.50 per direct labor hour.
Analyze Results
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Because the predetermined rate is an estimate, cost accountants should expect a difference between actual overhead costs incurred throughout the year and the amount applied via the overhead rate. Depending on the magnitude of the difference, the difference will be charged to cost of goods sold or allocated among the cost of goods sold account and the work in process and ending inventory accounts.
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