Calculating the Predetermined Rates
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.Predetermined Overhead Rate Calculation
Use of Multiple Predetermined Rates in Allocation
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 of $35, 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% |
Not only can the predetermined overhead rate differ from department to department, but the allocation base can also differ between departments. The allocation base must be a cost driver. A cost driver is any reason or factor that creates or causes a change in an expense. The most common allocation base for a company that makes products is direct labor hours or direct labor dollars. In some departments, the allocation base could be machine hours. But in other departments, where there are limited machine hours, labor hours may be a better choice. By using departmental predetermined overhead rates, managers can select the best allocation base for each department. Using these rates increases the accuracy of the cost per operation.
While using multiple predetermined overhead rates is generally more accurate than using a plantwide rate, problems can occur when using multiple rates. When costs are not easily separated by department, then accurate department rates are difficult to determine. Use of department rates requires more work by the accountant and department manager to calculate and maintain the multiple rates. And if costs and production requirements are fairly similar between departments, then the additional work and cost to create department rates are not worth the effort and expense.