## Job Order Costing

### Calculating the Predetermined Rates

A predetermined overhead rate requires estimating of future costs.
Companies keep track of costs by assigning indirect manufacturing expenses to a product throughout the manufacturing process. To do this, the accountant must establish a predetermined overhead rate. To calculate this estimated amount, the accountant works through five steps to determine the predetermined overhead rate by dividing the estimated manufacturing fixed costs for the accounting period by the allocation base.
${\text{Predetermined Overhead Rate}=\frac{\text{Estimated Manufacturing Overhead}}{\text{Allocation Base}}}$
A useful and accurate predetermined overhead rate will need to take into account both variable and fixed costs that are manufacturing overhead. The first step a company takes in creating a predetermined overhead rate is to select an allocation base. The base selected must be part of all manufacturing processes. For this reason, direct labor hours or direct labor costs are the most commonly used allocation bases.

The predetermined overhead rate is based on an estimate of overhead costs, production needed, and sales. Historic information is used to help create the projections. The second step in creating a predetermined overhead rate involves determining the estimated manufacturing overhead. The accountant pulls all accounts historically classified as "manufacturing." Historic figures are adjusted by management's anticipated changes in any of these areas. For instance, if the company has set a 2% salary increase budget for the new year, past year supervisor salaries will be increased by the 2% for the figure used in calculating the estimated manufacturing overhead for the new year.

The third step involves determining the projected sales. The sales/marketing department normally provides projected sales. However, sales projections need to take into consideration the company's production capacity.

The fourth step involves the direct labor hours (allocation base) needed to produce the number of estimated units to be sold. The direct labor hours are based on historic production information. Once all of this information is compiled, managers can apply the basic predetermined overhead rate calculation to provide the predetermined overhead rate for the upcoming year.

For example, Transglobal United Manufacturing estimated manufacturing overhead for the upcoming year to be $250,000, with 120,000 units sold for the year (10,000 units sold each month). The per-unit fixed cost for manufacturing overhead is$1.25 per unit. If the company produces 10,000 units per month but sells only 5,000 units each month, then inventory will increase by 5,000 units each month. If managers consider only the cost per unit, then producing 10,000 units seems to be the most cost-effective level because it keeps per-unit costs low. But integrating valid sales projections and inventory management means that the company will most likely reduce the production level to 5,000 units per month. With only half as many units being produced, the fixed cost portion of the predetermined overhead rate rises to 2.50. {\begin{aligned}\1.25\;{(\text {Predetermined Overhead Rate)}}&=\frac{\rm{\250{,}000}\;{(\text{Estimated Manufacturing Overhead})}}{\rm{120{,}000}\;{(\text{Estimated Sales units})}}\\\\\2.50\;{(\text{Predetermined Overhead Rate})}&=\frac{{\rm \250{,}000}\;{(\text{Estimated Manufacturing Overhead})}}{\rm{60{,}000}\;{(\text{Estimated Sales Units})}}\end{aligned}} Overhead costs typically reflect between 150% and 250% of the cost of direct labor, so the change in amount of overhead applied to an item can greatly influence the price to the customer. ### Use of Multiple Predetermined Rates in Allocation A company may use one predetermined overhead rate for simplicity or blend multiple rates from different departments to determine costs more accurately. For the sake of simplicity, a company can use a single amount used across all production processes to charge indirect, factory-related production costs to items, known as a plantwide overhead rate. However, a company does not have to use the same rate in all manufacturing areas. Instead, the company can use multiple predetermined overhead rates, which are a system in which each department or product has a different amount charged to it for a fixed cost, depending on the production processes. Plantwide predetermined overhead rates have the advantage of examining the production process in its entirety. Departmental predetermined overhead rates have the advantage of improving department-level management control and input. Using a departmental approach engages the department manager in creating the rates, providing more accurate information on the movement of specific costs. When a plantwide rate is used, managers may not notice problems with excess use of manufacturing supplies in one area if those problems are hidden by the efficient use in other departments. Significant differences in labor costs between departments can also be a reason to use multiple predetermined overhead rates. If a company uses labor hours as an allocation base, then adding the same rate to every department can skew the true cost of labor. For example, if the machining department has an average labor rate of35, then the addition of a $2 overhead rate per hour is an increase of less than 6%. If the finishing department has an average labor rate of$10, then using the $2 overhead rate increases that labor cost by 20%. Increasing a direct cost significantly by applying overhead can mislead managers as they make decisions about cost control. Department Average Labor Rate Overhead Rate Total Labor Rate Labor Rate Increase Due to Overhead Rate Machining department$35 $2$37 6%
Finishing department $10$2 \$12 20%