Predetermined overhead rate is used to apply manufacturing overhead to products or job orders and is usually computed at the beginning of each period by dividing the estimated manufacturing overhead cost by an allocation base (also known as activity base or activity driver). Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials.
The formula of predetermined overhead rate is written as follows:
Suppose GX company uses direct labor hours to assign manufacturing overhead cost to job orders. The budget of the GX company shows an estimated manufacturing overhead cost of $8,000 for the forthcoming year. The company estimates that 1,000 direct labors hours will be worked in the forthcoming year.
Using the above information, we can compute the predetermined overhead rate as follows:
= $8,000 / 1,000 hours
= $8.00 per direct labor hour
Notice that the formula of predetermined overhead rate is entirely based on estimates. The overhead applied to products or job orders would, therefore, be different from the actual overhead incurred by jobs or products. This difference is eliminated at the end of the period. The elimination of difference between applied overhead and actual overhead is known as disposition of over or under applied overhead.
Multiple Predetermined overhead rate:
The predetermined overhead rate computed above is known as single predetermined overhead rate or plant-wide overhead rate. It is mostly used by small companies. In large companies, each production department computes its own predetermined overhead rate. The use of multiple predetermined overhead rates may be complex and time consuming but is considered more accurate than a single plant-wide overhead rate.
According to a survey 34% of the manufacturing businesses use a single plant wide overhead rate, 44% use multiple predetermined overhead rates and rest of the companies use activity based costing (ABC) system.