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 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.
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.
| 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.
| 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).
| 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).
| 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.
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.