Pre-determined Overhead Rate

Pre-determined overhead rate (also called overhead absorption rate) is the rate at which the manufacturing overheads are charged to work-in-process based on some underlying activity base such as direct labor hours, machine hours, etc.

Pre-determined overhead rate is calculated at the start of a managerial accounting cycle based on total budgeted overheads cost and some relevant cost driver such as total budgeted labor hours, total budgeted labor cost, machine hours, etc.

Since actual manufacturing overhead costs are compiled at the period end only, the overhead application based on pre-determined overhead rate is useful in costing products. At the end of managerial accounting cycle, the difference between manufacturing overheads applied and actual manufacturing overheads is adjusted.

Formula

Pre-determined overheads rate equals estimated manufacturing overheads divided by total units of the cost driver (i.e. allocation base):

Pre-determined Overhead Rate = Estimated Manufacturing Overheads ÷ Total Units of Cost Driver

Manufacturing overheads are applied to a product by multiplying the pre-determined overhead rate with units of the cost driver:

Manufacturing Overheads Applied = Overhead Rate × Units of Cost Driver Consumed

Example

Chinar Pharmaceuticals is commencing its next accounting year. It expects to incur total manufacturing overheads of $10 million. During the year total labor costs are expected to be $3 million for a 5,000 total labor hours and total machine operating hours are budgeted at 100,000.

Find the pre-determined overhead rate.

The company has a product named X1 which consumed 25,000 machine operating hours, find the manufacturing overheads to be charged to the product.

Solution

Chinar Pharmaceuticals can calculate pre-determined overheads based either on total labor cost, total labor hours or total processing hours. Selection of a cost driver is a matter of judgment. Since the company is not very labor intensive, use of machine operating hours as a cost driver seems appropriate.

Pre-determined overhead rate based on machine operating hours equals total budgeted manufacturing overheads (of $1,000,000) divided by total budgeted machine operating hours (which are 100,000). It gives us a pre-determined overhead rate of $10 per machine operating hour.

Manufacturing overheads charged to X1 = pre-determined overhead rate × machine operating hours consumed by X1 = $10 per machine operating hour × 25,000 machine operating hours = $250,000.

Written by Obaidullah Jan, ACA, CFA and last revised on