Month: септември 2023

4 4: Compute a Predetermined Overhead Rate and Apply Overhead to Production Business LibreTexts

When companies manufacture products, sell merchandise, or provide services, they experience a variety of costs in the process. Some of those costs are directly related to a specific process, such as direct labor, direct materials, and billable (to the customer) costs, while others are not. Overhead costs is the term used to refer to expenses that are not directly related to any specific task or job. Examples of overhead costs include rent, utilities, office supplies, and administrative salaries. For example, the total direct labor hours estimated for the solo product is 350,000 direct labor hours.

Direct Costs vs. the Overhead Rate

The predetermined overhead rate was found by dividing the estimated manufacturing overhead cost by the estimated total units in the allocation base, so the predetermined overhead cost per unit is $9.00. Traditionally, direct labor hours were used as the activity base, but technology continually decreases the amount of direct labor used in production, and machine hours or units produced have become more common activity bases. Management analyzes the costs and selects the activity as the estimated activity base because it drives the overhead costs of the unit.

Determining Estimated Overhead Cost

The overhead rate is a cost added on to the direct costs of production in order to more accurately assess the profitability of each product. In more complicated cases, a combination of several cost drivers may be used to approximate overhead costs. Direct predetermined overhead rate labor standard rate, machine hours standard rate, and direct labor hours standard rate are some methods of factory overhead absorption. The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed.

1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory. The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period. The second step is to estimate the total manufacturing cost at that level of activity.

• As you have learned, the overhead needs to be allocated to the manufactured product in a systematic and rational manner.
• Fixed costs would include building or office space rent, utilities, insurance, supplies, and maintenance and repair.
• Further, the company uses direct labor hours to assign manufacturing overhead costs to products.
• Costs must thus be estimated based on an overhead rate for each cost driver or activity.
• Since it is arduous to apply overhead cost to each individual cost object, such as a shoe, companies tend to use the average of an aggregate number of objects.

Concerns Surrounding Predetermined Overhead Rates

So, if you were to measure the total direct labor cost for the week, the denominator would be the total weekly cost of direct labor for production that week. Finally, you would divide the indirect costs by the allocation measure to achieve how much in overhead costs for every dollar spent on direct labor for the week. The predetermined overhead rate formula is calculated by dividing the estimated manufacturing overhead cost by the allocation base. The overhead rate allocates indirect costs to the direct costs tied to production by spreading or allocating the overhead costs based on the dollar amount for direct costs, total labor hours, or even machine hours.

• If you'd like to learn more about calculating rates, check out our in-depth interview with Madison Boehm.
• So, if you wanted to determine the indirect costs for a week, you would total up your weekly indirect or overhead costs.
• In contrast, the traditional allocation method commonly uses cost drivers, such as direct labor or machine hours, as the single activity.
• The predetermined overhead rate is then applied to production to facilitate determining a standard cost for a product.
• It is important to include indirect costs that are based on this overhead rate in order to price a product or service appropriately.
• The equation for the overhead rate is overhead (or indirect) costs divided by direct costs or whatever you're measuring.

4 Compute a Predetermined Overhead Rate and Apply Overhead to Production

by Георги Тенев