Predetermined overhead Rate Formula • How to calculate it

A default overhead rate is a tool typically applied to a product’s manufacturing overhead. It can also be used similarly when applied to work orders or strategies.

Typically, this overhead rate tends to be calculated at the beginning of accounting periods. The calculation is based on the division of the manufacturing overhead cost by an allocation base, also known as activity base or activity drivers.

Although there may be other factors and systems of application, allocation bases are usually calculated using direct labor hours, hours of machinery employed, and raw material costs in the production or manufacturing process.

That would lead us to a formula with different applied methods.

Formula and calculation

To perform the calculation, the predetermined indirect cost rate is usually derived using a division over the indirect manufacturing cost that is estimated (or budgeted) by the estimated units within the allocation base. These calculations are performed at the beginning of the estimated period in which the analysis is to be made.

Therefore, the result would say that the predetermined overhead rate equals the estimated cost of manufacturing divided by the units in the allocation base.

For example, a company uses a certain amount of direct labor hours allocated to overhead costs within it’s production. In this case, this companies budget will show estimated manufacturing overhead costs related to direct labor hours over a while—for example, one year.

The indirect manufacturing cost should be divided by the estimated hours in this case. That would yield a cost price per direct labor job.

Bearing that this formula will be based entirely on estimates, it must understand that it is not an exact formula. Therefore, on many occasions, we will combine it with other types of calculation and accounting tools or systems.

In addition, the overhead comparisons applied will show the number of overhead overruns and underruns. It is interesting to note that by eliminating the differences between the applied overhead and the actual overhead, we obtain what is called over/under overhead provisions.

How to understand the general tariffs

The default overhead rate is known as the single or plant overhead rate. It is a model that, although we can apply it in other formats, is generally going to be used in small companies. In a large company, production departments commonly calculate the different rates that are added to the overhead.

A complex and often time-consuming task model is established when many predetermined overhead rates are used. However, this time spent at the same time is a provider of more accurate approaches. If we remember, we said earlier that the calculation is usually not accurate. Therefore, using tools that improve the precise system is very interesting. 

The cost of the work order

A final element that can be considered is the job order cost. The job order cost is another tool used by companies that manufacture different types of products. It is a very common system in the manufacturing industry.

When using a job order costing system, it is often said that the work orders, also known as lots, will add up to the total volume on which the job order costing is performed.

For example, if a company accepts an order or a job on different services or products, it is very complex to establish the cost allocation. In this case, the recording of costs per individual job is usually maintained: this is because each job will have a different product and, therefore, another price.

The calculation per unit of work is made when the total cost assigned to the job is divided by the number of units.