4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
2 min read•june 18, 2024
Predetermined overhead rates are a crucial tool in managerial accounting. They allow companies to estimate and apply overhead costs to products before the actual costs are known, enabling timely decision-making and consistent cost reporting throughout the period.
The process involves calculating a rate based on estimated costs and activity levels, then applying it to actual production. This method smooths out cost fluctuations, simplifies overhead allocation, and facilitates cost analysis and pricing decisions.
Predetermined Overhead Rates and Application
Predetermined overhead rate calculation
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- Estimates total overhead costs and activity base before the period begins
- Enables timely reporting and decision making throughout the period
- Evens out overhead cost fluctuations (seasonal variations, production volume changes)
- formula:
- Allocation base measures activity driving overhead costs (direct labor hours, machine hours, units produced)
- Determines overhead cost per unit of activity (rate per direct labor hour, rate per machine hour)
- Calculating predetermined rate example:
- Estimated overhead costs: $100,000
- Estimated direct labor hours: 5,000
- Predetermined rate: 100,000 / 5,000 hours)
Overhead application to production
- Applies overhead costs to products or services using predetermined rate and actual activity level
- Assigns a portion of overhead costs to each unit produced
- Calculates total production cost (direct materials + direct labor + )
- Applied overhead formula: \text{[Predetermined overhead rate](https://www.fiveableKeyTerm:Predetermined_Overhead_Rate)} \times \text{Actual activity level}
- Multiplies predetermined rate by actual activity consumed (actual direct labor hours worked, actual machine hours used)
- Applying overhead example:
- Predetermined rate: $20 per direct labor hour
- Actual direct labor hours: 4,800
- Applied overhead: 20 × 4,800 hours)
- Adds $96,000 to total production cost for the period
Rationale for predetermined rates
- Actual overhead costs unknown until period ends
- Using actual costs delays reporting and decision making
- Hinders timely cost control and variance analysis
- Predetermined rates enable timely reporting and management
- Allows comparing applied overhead to actual overhead costs throughout period
- Identifies variances for investigation ( or )
- Smooths overhead cost fluctuations over time
- Provides more consistent unit costs (avoids extreme high or low costs due to volume changes)
- Aids in pricing and budgeting decisions
- Simplifies overhead to products or jobs
- Avoids tracking actual overhead costs consumed by each product (time-consuming, complex)
- Applies overhead based on readily available activity measures (direct labor hours, machine hours)
- Facilitates by providing consistent overhead costs
Costing Methods
- : Uses predetermined overhead rates and actual
- : Uses actual overhead and direct costs, but delays reporting
- : Assigns overhead based on multiple cost drivers for more accurate product costing
Key Terms to Review (36)
Activity-based costing: Activity-Based Costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. It identifies specific activities within an organization and assigns the cost of each activity to all products and services according to the actual consumption by each.
Activity-Based Costing: Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to the various products and services according to the actual consumption by each. It is a more accurate way of allocating overhead costs compared to traditional volume-based costing methods.
Actual Costing: Actual costing is a method of product costing where the actual costs incurred in the production process are used to determine the final cost of a product. This contrasts with predetermined costing, where estimated costs are used to calculate product costs in advance.
Administrative Overhead: Administrative overhead refers to the indirect costs associated with the overall management and administration of a business, rather than the direct costs of producing a product or providing a service. It encompasses the expenses incurred for the general operations and support functions that are necessary to sustain the organization's activities.
Applied Overhead: Applied overhead refers to the portion of a company's indirect manufacturing costs that are assigned or allocated to the production of goods or services during a specific accounting period. It represents the estimated or predetermined overhead costs that are applied to the manufacturing process based on a predetermined overhead rate.
Balance Sheet: The balance sheet is a financial statement that provides a snapshot of a company's assets, liabilities, and equity at a specific point in time. It is a fundamental tool for understanding a company's financial position and is crucial for both merchandising, manufacturing, and service organizations.
Cost Allocation: Cost allocation is the process of assigning indirect or overhead costs to specific cost objects, such as products, services, or departments, based on a rational and systematic method. It is a crucial concept in managerial accounting that helps organizations accurately determine the true cost of their operations and make informed decisions.
Cost driver: A cost driver is a factor that causes or influences the cost of an activity. It helps in identifying and allocating costs more accurately in cost accounting and management.
Cost Driver: A cost driver is a factor or activity that directly influences the incurrence of a particular cost within an organization. It is a key concept in understanding and managing costs, as it helps identify the underlying causes of cost behavior and guides decision-making processes.
Cost Object: A cost object is any item, such as a product, service, or activity, for which costs are measured and assigned. It serves as the target for which costs are accumulated and analyzed, allowing organizations to understand the financial implications of their operations.
Cost pool: A cost pool is an aggregation of individual costs, typically by department or service center, from which cost allocations are made later. It simplifies the process of assigning costs to various products or services.
Cost Pool: A cost pool is a grouping of individual cost items or cost centers that are similar in nature and can be allocated to cost objects using the same allocation base. Cost pools are an essential component in both traditional and activity-based costing systems, as they facilitate the accurate assignment of overhead costs to products or services.
Cost-Volume-Profit Analysis: Cost-Volume-Profit (CVP) analysis is a managerial accounting technique that examines the relationship between a company's costs, volume of output, and profitability. It provides insights into how changes in these factors can impact a business's overall financial performance, helping managers make informed decisions.
Departmental Rate: The departmental rate is a predetermined overhead rate that is calculated and applied to production within a specific department or cost center of an organization. It is used to allocate overhead costs to products or services based on the activity and resource consumption of that particular department.
Direct Costs: Direct costs are expenses that can be directly attributed to the production of a specific product or service. These costs are easily traceable to the individual unit or cost object and are essential in determining the total cost of manufacturing a product or providing a service.
Estimated activity base: An estimated activity base is a measure used to allocate overhead costs to products or job orders. It is determined before the period begins and serves as a basis for calculating the predetermined overhead rate.
Income Statement: An income statement is a financial report that summarizes a company's revenues, expenses, and profits or losses over a specific period. It provides insight into a company's operational performance and is crucial for assessing profitability. The income statement varies based on the type of organization, including merchandising, manufacturing, and service organizations, as each has different revenue recognition and expense reporting methods.
Indirect Costs: Indirect costs are expenses incurred in the production of goods or services that cannot be easily traced to a specific cost object, such as a product or a department. These costs are not directly attributable to the manufacture of a particular item but are necessary for the overall operation of a business. Indirect costs are an important consideration in various managerial accounting topics, including the computation of a predetermined overhead rate, the preparation of journal entries for a job order cost system, the application of a job order cost system to a nonmanufacturing environment, the calculation of predetermined overhead and total cost under the traditional allocation method, and the comparison of traditional and activity-based costing systems.
Job cost sheet: A job cost sheet is a document that records and accumulates all the costs assigned to a specific job in job order costing. It includes direct materials, direct labor, and manufacturing overhead costs.
Job Cost Sheet: A job cost sheet is a detailed record that tracks and accumulates the direct materials, direct labor, and manufacturing overhead costs associated with a specific job or production order in a job order costing system. It serves as a key document for determining the total cost of a job and the cost of goods manufactured.
Job order costing: Job order costing is a costing method used to allocate costs to specific jobs or orders, often for products that are distinctly different from each other. It tracks direct materials, direct labor, and manufacturing overhead costs for each job individually.
Job Order Costing: Job order costing is an accounting method used to track and accumulate the costs associated with the production of specific, distinct products or services. It focuses on tracing the direct costs of materials, labor, and overhead to individual jobs or batches of products rather than to the overall production process.
Manufacturing overhead: Manufacturing overhead includes all indirect costs associated with the production process, such as utilities, maintenance, and factory supplies. It does not include direct materials or direct labor costs.
Manufacturing Overhead: Manufacturing overhead refers to the indirect costs associated with the production of goods in a manufacturing organization. These are the costs that cannot be directly traced to a specific product but are necessary for the overall manufacturing process. Manufacturing overhead encompasses a wide range of expenses, including indirect materials, indirect labor, and other factory-related costs.
Normal Costing: Normal costing is a method of product costing that uses predetermined overhead rates to assign indirect manufacturing costs to products. It is a widely used approach in managerial accounting that aims to provide a more accurate and consistent way of allocating overhead expenses to individual products or cost objects.
Over-applied Overhead: Over-applied overhead refers to a situation where the actual overhead costs incurred by a business exceed the predetermined overhead rate used to allocate overhead to production. This results in a surplus or credit balance in the overhead control account, indicating that more overhead was applied to production than was actually incurred.
Overhead Application Rate: The overhead application rate is a predetermined rate used to allocate overhead costs to production. It is calculated by dividing the estimated total overhead costs by the expected activity or volume measure, such as direct labor hours or machine hours. This rate is then used to apply overhead to individual jobs or products in a job order cost system.
Overhead Rate Formula: The overhead rate formula is a calculation used to determine the rate at which overhead costs should be applied to production. It is a crucial tool in managerial accounting for accurately allocating indirect costs to products or services, enabling informed decision-making and cost management.
Plantwide Rate: The plantwide rate is a predetermined overhead rate that is calculated based on the total estimated overhead costs for an entire manufacturing facility or plant, rather than for individual departments or cost centers. It is used to apply overhead costs to production in a simplified, uniform manner across the entire organization.
Predetermined overhead rate: The predetermined overhead rate is a calculation used to allocate estimated manufacturing overhead costs to products or job orders, based on a specific activity base, such as direct labor hours or machine hours. It is determined before the period begins and helps in budgeting and costing processes.
Predetermined Overhead Rate: The predetermined overhead rate is a method used in job order costing to apply overhead costs to individual jobs or products. It is calculated by dividing the estimated total overhead costs for a period by the estimated activity base, such as direct labor hours or machine hours, for that same period. This rate is then used to apply overhead to each job based on the job's actual usage of the activity base.
Process costing: Process costing is a method used to allocate costs in industries where production is continuous and units are indistinguishable from each other. It assigns average costs to each unit produced during a specific period.
Process Costing: Process costing is a cost accounting system used to determine the per-unit cost of a product or service when a company manufactures identical products or services in a continuous or repetitive fashion. It focuses on calculating the average cost per unit by allocating total costs across all units produced in a given period.
Production cost report: A production cost report summarizes the total costs incurred by a processing department and calculates the cost per unit for products during a specific period. It is essential for managing and controlling production costs in process costing systems.
Production Cost Report: A production cost report is a financial statement that summarizes the total cost of producing goods or services within a specific time period. It provides a detailed breakdown of the various cost components involved in the production process, including direct materials, direct labor, and manufacturing overhead.
Under-Applied Overhead: Under-applied overhead refers to a situation where the actual overhead costs incurred by a business exceed the amount of overhead that has been applied to the products or services produced. This occurs when the predetermined overhead rate used to allocate overhead to production is lower than the actual overhead rate.