Mastering Predetermined Overhead Rate: A Comprehensive Guide for Accurate Costing
Understanding and accurately calculating the predetermined overhead rate (POHR) is crucial for businesses that want to accurately cost their products or services. This rate helps allocate indirect manufacturing costs, also known as overhead, to individual products or jobs before the actual costs are known. Without a POHR, businesses would have to wait until the end of the accounting period to allocate overhead, delaying cost analysis and potentially leading to poor pricing decisions. This comprehensive guide will walk you through the steps of calculating POHR, explain its significance, and illustrate its application with practical examples.
## What is Predetermined Overhead Rate (POHR)?
The predetermined overhead rate is an estimated overhead rate used to apply overhead costs to products or services. It’s calculated *before* the accounting period begins, using estimated overhead costs and an estimated activity level. This contrasts with using actual overhead costs and actual activity levels, which would only be available at the end of the period.
The formula for calculating the predetermined overhead rate is:
**Predetermined Overhead Rate (POHR) = Estimated Total Overhead Costs / Estimated Total Activity Level**
## Why Use a Predetermined Overhead Rate?
There are several compelling reasons why businesses choose to use a POHR:
* **Timely Costing:** As mentioned earlier, a POHR allows businesses to apply overhead costs to products or services as they are produced or performed, providing more immediate cost information. This is particularly useful for job costing systems where each job needs to be individually costed.
* **Pricing Decisions:** With readily available cost data, businesses can make informed pricing decisions, ensuring that prices cover all costs, including overhead, and provide a desired profit margin.
* **Budgeting and Planning:** The POHR serves as a benchmark for planning and budgeting. By estimating overhead costs in advance, businesses can better control spending and identify areas for cost reduction.
* **Smoothing Out Fluctuations:** Actual overhead costs can fluctuate significantly from month to month due to seasonal factors or one-time expenses. A POHR helps to smooth out these fluctuations, providing a more stable and predictable cost structure.
* **Performance Measurement:** By comparing actual overhead costs to applied overhead costs (calculated using the POHR), businesses can assess the efficiency of their overhead spending and identify areas where improvements can be made.
## Steps to Calculate Predetermined Overhead Rate
Now, let’s delve into the detailed steps involved in calculating the predetermined overhead rate.
**Step 1: Identify the Cost Pool and Cost Driver**
* **Cost Pool:** The cost pool is a grouping of all indirect costs that need to be allocated to products or services. These costs are typically related to the manufacturing process but are not directly traceable to individual products. Common examples of overhead costs include:
* Indirect labor (e.g., factory supervisors, maintenance personnel)
* Indirect materials (e.g., lubricants, cleaning supplies)
* Factory rent
* Factory utilities (electricity, gas, water)
* Depreciation of factory equipment
* Property taxes on factory building
* Factory insurance
* **Cost Driver:** The cost driver is the activity that causes overhead costs to be incurred. It’s the base used to allocate overhead costs to products or services. Selecting the right cost driver is crucial for accurate costing. Common cost drivers include:
* Direct labor hours
* Direct labor cost
* Machine hours
* Units produced
* Square footage (for rent or utilities)
The selection of the cost driver should be based on a strong correlation between the cost driver and the overhead costs. In other words, changes in the cost driver should significantly impact the overhead costs. For example, if machine hours directly influence electricity consumption in the factory, machine hours would be a suitable cost driver for electricity costs.
**Example:**
Let’s say a company manufactures widgets. They have identified the following overhead costs:
* Indirect Labor: $50,000
* Factory Rent: $20,000
* Factory Utilities: $10,000
* Depreciation of Equipment: $15,000
Total Estimated Overhead Costs: $95,000
The company also needs to choose a cost driver. After analysis, they determine that direct labor hours are the most appropriate driver for their overhead costs because more direct labor hours generally mean more equipment usage and more support from indirect labor.
**Step 2: Estimate Total Overhead Costs**
This step involves estimating the total amount of overhead costs that will be incurred during the accounting period (usually a year). This estimate should include all costs identified in the cost pool. The accuracy of this estimate is crucial for the accuracy of the POHR. Businesses use different techniques for estimating overhead costs, including:
* **Historical Data:** Analyzing past overhead costs to identify trends and patterns.
* **Budgeting:** Developing a detailed budget that includes estimated overhead costs.
* **Forecasting:** Using statistical models to predict future overhead costs based on historical data and other relevant factors.
* **Expert Opinion:** Consulting with experienced managers and employees to gather insights into potential overhead costs.
Consider various factors like anticipated production volume, changes in technology, economic conditions, and any planned improvements that could impact overhead costs when creating the estimate.
**Example (Continuing from Step 1):**
As already stated, the company has estimated its total overhead costs to be $95,000.
**Step 3: Estimate Total Activity Level**
This step involves estimating the total amount of the chosen cost driver that will occur during the accounting period. This estimate should be consistent with the estimate of total overhead costs. For example, if the cost driver is direct labor hours, the company needs to estimate the total number of direct labor hours that will be worked during the year.
Accurate activity level estimation methods include:
* **Production Budgets:** Using production budgets to determine the required level of direct labor hours or machine hours.
* **Sales Forecasts:** Using sales forecasts to estimate the demand for products and the corresponding activity levels.
* **Historical Data:** Analyzing past activity levels to identify trends and patterns.
**Example (Continuing from Step 2):**
The company estimates that it will incur 25,000 direct labor hours during the year.
**Step 4: Calculate the Predetermined Overhead Rate**
Now that you have estimated the total overhead costs and the total activity level, you can calculate the POHR using the formula:
**Predetermined Overhead Rate (POHR) = Estimated Total Overhead Costs / Estimated Total Activity Level**
**Example (Continuing from Step 3):**
Using the data from the previous steps:
POHR = $95,000 / 25,000 direct labor hours = $3.80 per direct labor hour
Therefore, the predetermined overhead rate is $3.80 per direct labor hour. This means that for every direct labor hour worked, the company will allocate $3.80 of overhead costs to the product or service being produced.
## Applying Overhead Costs
Once the POHR has been calculated, it can be used to apply overhead costs to individual products or services. This is done by multiplying the POHR by the actual activity level incurred for each product or service.
**Applied Overhead = Predetermined Overhead Rate x Actual Activity Level**
**Example:**
Suppose a specific widget required 2 direct labor hours to produce. The applied overhead cost for that widget would be:
Applied Overhead = $3.80 per direct labor hour x 2 direct labor hours = $7.60
Therefore, $7.60 of overhead costs would be allocated to that particular widget.
## Overapplied and Underapplied Overhead
It’s important to understand the concepts of overapplied and underapplied overhead, as they often occur when using a POHR.
* **Overapplied Overhead:** Occurs when the applied overhead costs are greater than the actual overhead costs incurred during the period. This means that more overhead was allocated to products or services than was actually spent.
* **Underapplied Overhead:** Occurs when the applied overhead costs are less than the actual overhead costs incurred during the period. This means that not enough overhead was allocated to products or services.
The difference between applied overhead and actual overhead is called the overhead variance. This variance must be addressed at the end of the accounting period.
**Calculating Overapplied or Underapplied Overhead:**
Overapplied/Underapplied Overhead = Actual Overhead Costs – Applied Overhead
* If the result is negative, it means overhead is overapplied.
* If the result is positive, it means overhead is underapplied.
**Example:**
Let’s say the actual overhead costs incurred during the year were $90,000, and the actual direct labor hours worked were 24,000. The applied overhead would be:
Applied Overhead = $3.80 per direct labor hour x 24,000 direct labor hours = $91,200
Overapplied/Underapplied Overhead = $90,000 – $91,200 = -$1,200
In this case, the overhead is overapplied by $1,200.
## Dealing with Overapplied or Underapplied Overhead
There are two primary methods for dealing with overapplied or underapplied overhead:
* **Closing to Cost of Goods Sold (COGS):** This is the most common method. The overapplied or underapplied overhead is simply closed to the Cost of Goods Sold account. If overhead is overapplied, COGS is decreased; if overhead is underapplied, COGS is increased.
* **Allocating to Work-in-Process (WIP), Finished Goods, and COGS:** This method is more complex and is typically used when the overapplied or underapplied overhead is significant. The overapplied or underapplied overhead is allocated proportionally to the balances in the Work-in-Process, Finished Goods, and Cost of Goods Sold accounts.
**Example (Continuing from the previous example, using the Closing to COGS method):**
Since the overhead was overapplied by $1,200, the following journal entry would be made:
Debit: Manufacturing Overhead $1,200
Credit: Cost of Goods Sold $1,200
This entry reduces the Cost of Goods Sold by $1,200, reflecting the fact that too much overhead was initially allocated to products.
## Choosing the Right Cost Driver: Important Considerations
The selection of the most appropriate cost driver is critical for an accurate POHR. Here are some essential considerations:
* **Correlation:** As emphasized earlier, a strong correlation must exist between the cost driver and the overhead costs. A high correlation coefficient between the two is ideal.
* **Causality:** Ideally, the cost driver should *cause* the overhead costs to be incurred. While correlation is important, causality provides a stronger basis for allocation.
* **Availability of Data:** The data for the cost driver should be readily available and easily measurable. If tracking the cost driver is too costly or time-consuming, it might not be the best choice.
* **Simplicity:** The cost driver should be relatively simple to understand and use. Complex cost drivers can lead to errors and confusion.
* **Industry Practices:** Consider industry benchmarks and common practices when selecting a cost driver. While not always definitive, these can provide valuable insights.
**Common Mistakes to Avoid When Calculating POHR**
* **Inaccurate Estimates:** Overestimating or underestimating overhead costs or activity levels can significantly distort the POHR.
* **Using an Inappropriate Cost Driver:** Selecting a cost driver with a weak correlation to overhead costs can lead to inaccurate cost allocations.
* **Including Non-Manufacturing Costs:** Overhead costs should only include costs related to the manufacturing process. Administrative and selling expenses should not be included.
* **Failing to Adjust for Changes:** The POHR should be reviewed and adjusted periodically to reflect significant changes in overhead costs or activity levels.
* **Ignoring the Impact of Automation:** As companies become more automated, direct labor hours may become a less relevant cost driver. Machine hours or other measures of automation may be more appropriate.
## POHR and Activity-Based Costing (ABC)
While POHR is a valuable tool, it can be less accurate than Activity-Based Costing (ABC), especially in complex manufacturing environments. ABC identifies and assigns costs to specific activities and then allocates those activity costs to products or services based on their consumption of those activities.
While POHR often uses a single, plant-wide rate, ABC uses multiple cost drivers and cost pools, allowing for a more precise allocation of overhead costs. For example, instead of using just direct labor hours, ABC might use setup hours, inspection hours, and engineering hours as cost drivers.
While ABC is more complex to implement, it provides a more accurate picture of product costs, which can be particularly useful for making strategic decisions about pricing, product mix, and process improvements.
## Advantages and Disadvantages of Using POHR
**Advantages:**
* **Simplicity:** Relatively easy to calculate and implement.
* **Timely Costing:** Provides timely cost information for pricing and decision-making.
* **Budgeting and Planning:** Facilitates budgeting and planning by providing a benchmark for overhead costs.
* **Smoothing Out Fluctuations:** Helps to smooth out fluctuations in actual overhead costs.
**Disadvantages:**
* **Potential Inaccuracy:** Can be less accurate than ABC, especially in complex environments.
* **Reliance on Estimates:** Accuracy depends on the accuracy of the estimates used in the calculation.
* **Single Rate Assumption:** Assumes a uniform relationship between overhead costs and the cost driver, which may not always be the case.
## Real-World Examples
* **Manufacturing Company:** A furniture manufacturer uses machine hours as its cost driver to allocate overhead costs such as depreciation, utilities, and maintenance. By calculating the POHR based on machine hours, they can accurately determine the overhead cost associated with each piece of furniture produced.
* **Construction Company:** A construction company uses direct labor hours as its cost driver to allocate overhead costs such as site supervision, equipment rental, and insurance. By calculating the POHR based on direct labor hours, they can accurately determine the overhead cost associated with each construction project.
* **Printing Company:** A printing company uses machine hours to allocate overhead costs like electricity and machine maintenance. By calculating the POHR using estimated overhead and machine hours, they can apply a consistent overhead cost to each print job.
## Conclusion
Calculating the predetermined overhead rate is a fundamental aspect of cost accounting that enables businesses to allocate indirect manufacturing costs to products or services in a timely and efficient manner. While it relies on estimations and may not be as precise as Activity-Based Costing, it provides valuable cost information for pricing decisions, budgeting, and performance measurement. By carefully selecting the appropriate cost driver and accurately estimating overhead costs and activity levels, businesses can leverage the POHR to gain a better understanding of their cost structure and improve their overall profitability. Understanding the concepts of overapplied and underapplied overhead and having methods to address these variances are also important for accurate reporting. This guide has provided a detailed roadmap for mastering the predetermined overhead rate, empowering you to make more informed business decisions.
By following the steps outlined in this guide, you can effectively calculate and apply overhead costs, leading to more accurate product costing and improved decision-making. Remember to regularly review and adjust your POHR as needed to reflect changes in your business environment.