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REDETERMINED OVERHEAD RATES Since there are many types of manufacturing costs that fall into the indirect category, (i.e., common or shared costs that cannot easily be traced to any particular product or job) some method is needed to charge, allocate or apply these costs to the products manufactured. A predetermined overhead rate provides a convenient way to accomplish this system requirement. Developing an overhead rate involves four steps that include: 1) choosing an activity measurement, or allocation basis, 2) choosing an activity level, 3) estimating indirect costs for the activity level chosen, and 4) calculating the rate. CHOOSING AN ALLOCATION BASIS The first step involves choosing the manner in which activity will be measured. This activity measurement becomes the allocation basis. In traditional cost systems, production volume is assumed to be the only major activity. Therefore, it seems logical that the number of units produced should be used as the activity measurement, or allocation basis. However, in a job order cost system, the units produced cannot serve as the activity measure because each unit, or group of units, tends to be different. For this reason, a measurement related to production volume such as direct labor hours, direct labor costs, or machine hours is normally used to represent production activity. Direct labor costs and hours are the two most popular allocation bases because this information is already captured by the payroll system. However, the overhead allocation basis should be closely associated with the overhead costs to be estimated. The techniques discussed in Chapter 3 can be used to look for an activity measure that is highly correlated with the various types of overhead costs and also meets the other requirements discussed in Chapter 3. Of course more than one allocation basis may be needed to accurately allocate (trace) the many different types of indirect costs to products. CHOOSING AN ACTIVITY LEVEL Before the period starts, cost estimates are made for each type of indirect resource based on a particular activity level chosen by management. This activity level can represent practical productive capacity, planned production, or some other level of capacity. These alternatives are discussed in more detail in subsequent chapters and other parts of the MAAW web site (e.g., see the note on denominator activity levels ). For now, we will assume that planned production for the year is used for this purpose. ESTIMATING COST FOR THE ACTIVITY LEVEL CHOSEN Before an overhead rate can be calculated, the analyst must estimate the indirect costs for the period based on the activity level chosen in the previous step. Any of the techniques discussed in Chapter 3 can be used for this purpose. Regression analysis is very useful for cost estimating. Learning curve analysis is also useful, particularly where the process, or work to be performed is relatively new to the company.
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CALCULATING AND USING THE RATE The overhead rate is calculated by dividing the total estimated overhead costs by the
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This note was uploaded on 04/03/2012 for the course ACCT 325 taught by Professor Warren during the Spring '08 term at Rutgers.

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