# Predetermined Overhead Rate

A predetermined overhead rate (pohr) is use to calculate the amount of manufacturing overhead which is to be applied to the cost of a product.

Manufacturing overheads are indirect costs which cannot be directly attributed to individual product units and for this reason need to be applied to the cost of a product using a predetermined overhead rate.

## Predetermined Overhead Rate Basis

In order to estimate the predetermined overhead rate it is first necessary to to decide on an activity base on which to apply overhead costs to a product.

The activity base for applying manufacturing overhead is normally a unit quantity which relates to the manufacturing process such as the following.

• Direct labor hours
• Direct labor costs
• Machine hours
• Material costs

The activity base needs to be a measure which will apply the manufacturing overhead to the products on a fair and impartial basis.

## Calculate Predetermined Overhead Rate

A predetermined overhead rate is calculated before the start of an accounting period. Depending on the size of the business the predetermined overhead rate might be calculated for the whole business or, for a larger business, separate rates might be calculated for each department using a suitable basis.

The predetermined overhead rate formula can be stated as follows. The overhead costs are estimated based on the estimated activity level.

## Applying the Overhead Rate

The manufacturing overhead costs are applied to the product based on the actual number of activity base units used during the accounting period.

Applied overhead = Predetermined overhead rate x Actual activity base units

## Pre-Determined Overhead Rate Examples

### Direct Labor Hours Example

Suppose a business uses direct labor hours as the activity base for calculating the pre-determined rate. If at the beginning of the year the business estimates that manufacturing overheads will be 50,000 and that the estimated activity level will be 40,000 labor hours, then the pre-determined overhead rate is calculated as follows.

```Predetermined overhead rate = Estimated overhead costs / Estimated activity base units
Predetermined overhead rate = 50,000 / 20,000 = 2.50
```

The overhead is applied to the product units at the rate of 2.50 for each labor hour used.

#### Applied overhead

If a job is in work in process and has recorded actual direct labor hours of 600 during an accounting period then the predetermined overhead applied to the job is calculated as follows.

```Applied overhead = Predetermined overhead rate x Actual activity base units
Applied overhead = 2.50 x 600 = 1,500
```

#### Actual Overhead

The applied overhead is 1,500. If the actual overhead at the end of the accounting period is 1,575 the overhead is said to be under applied by 75 (1,500 – 1,575) as shown in the table below.

Predetermined overhead rate using labor hours
Estimated overhead 50,000
Estimated labor hours 20,000
Predetermined overhead rate 2.50
Actual labor hours 600
Applied overhead 1,500
Actual overhead 1,575
Over/(-Under) applied overhead -75

### Direct Labor Cost Example

If the business uses labor costs instead of labor hours as the activity base and the estimated labor cost for the year is 200,800 then, assuming the estimated overheads remain as above at 50,000, the pre-determined manufacturing overhead rate is calculated as follows.

```Predetermined overhead rate = Estimated overhead costs / Estimated activity base units
Predetermined overhead rate = 50,000 / 200,800 = 0.2490
```

The overhead will be allocated to the product units at the rate of 0.2490 for each unit of labor cost.

#### Applied overhead

If a job in work in process has recorded actual labor costs of 6,000 for the accounting period then the predetermined overhead applied to the job is calculated as follows.

```Applied overhead = Predetermined overhead rate x Actual activity base units
Applied overhead = 0.2490 x 6,000 = 1,494
```

The estimated manufacturing overhead cost applied to the job during the accounting period will be 1,494.

#### Actual Overhead

Again the actual overhead at the end of the accounting period is 1,575 and the overhead is said to be under applied by 81 (1,494 – 1,575) as shown below.

Predetermined overhead rate using labor cost
Estimated overhead 50,000
Estimated labor cost 200,800
Predetermined overhead rate 0.2490
Actual labor cost 6,000
Applied overhead 1,494
Actual overhead 1,575
Over/(-Under) applied overhead -81

### Machine Hours Example

If the business uses machine hours as the activity base and the estimated machine hours for the year is 5,000 then the machine hour rate calculation formula can be used as follows to calculate the predetermined overhead rate.

```Predetermined overhead rate = Estimated overhead costs / Estimated activity base units
Predetermined overhead rate = 50,000 / 5,000 = 10.00
```

The overhead will be allocated to the product units at the rate of 10.00 for each machine hour used.

#### Applied overhead

If a job in work in process has recorded actual machine hours of 140 for the accounting period then the predetermined overhead applied to the job is calculated as follows.

```Applied overhead = Predetermined overhead rate x Actual activity base units
Applied overhead = 10.00 x 160 = 1,600
```

The estimated manufacturing overhead cost applied to the job during the accounting period will be 1,600.

#### Actual Overhead

If the actual overhead at the end of the accounting period is 1,575 the overhead is said to be over applied by 25 (1,600 – 1,575).

Predetermined overhead rate using machine hours
Estimated overhead 50,000
Estimated machine hours 5,000
Predetermined overhead rate 10.00
Actual machine hours 160
Applied overhead 1,600
Actual overhead 1,575
Over/(-Under) applied overhead 25

### Materials Cost Example

Finally, if the business uses material costs as the activity base and the estimated material costs for the year is 160,000 then the predetermined manufacturing overhead rate is calculated as follows.

```Predetermined overhead rate = Estimated overhead costs / Estimated activity base units
Predetermined overhead rate = 50,000 / 160,000 = 0.3125
```

The overhead will be allocated to the product units at the rate of 0.3125 for each unit of material cost used.

#### Applied overhead

If the job in work in process has recorded actual material costs of 4,640 for the accounting period then the predetermined overhead applied to the job is calculated as follows.

```Applied overhead = Predetermined overhead rate x Actual activity base units
Applied overhead = 0.3125 x 4,640 = 1,450
```

The estimated manufacturing overhead cost applied to the job during the accounting period will be 1,450.

#### Actual Overhead

If the actual overhead at the end of the accounting period is 1,575 the overhead is said to be under applied by 125 (1,450 – 1,575).

Pre-determined overhead rate using material cost
Estimated overhead 50,000
Estimated material cost 160,000
Predetermined overhead rate 0.3125
Actual material cost 4,640
Applied overhead 1,450
Actual overhead 1,575
Over/(-Under) applied overhead -125

The predetermined rate is based on estimates before the accounting period begins and is held constant throughout the period.

By using the predetermined rate product costs and therefore selling prices can be calculated quickly throughout the year without the need to wait for actual overheads to be determined and allocated. In addition while manufacturing overheads might vary seasonally throughout the year, the use of a constant predetermined rate avoids a similar variation in unit product cost.

At the end of the accounting period the applied overhead is compared to the actual overhead and any difference is posted to the cost of goods sold or, if significant, to work in process.

Last modified January 17th, 2020

## About the Author

Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.