Formula for calculating the Pre-determined Overhead Rate

A pre-determined overhead rate is the rate used to apply manufacturing overhead to work-in-process inventory. The pre-determined overhead rate is calculated before the period begins. The first step is to estimate the amount of the activity base that will be required to support operations in the upcoming period. The second step is to estimate the total manufacturing cost at that level of activity. The third step is to compute the predetermined overhead rate by dividing the estimated total manufacturing overhead costs by the estimated total amount of cost driver or activity base. Common activity bases used in the calculation include direct labor costs, direct labor hours, or machine hours.

This is related to an activity rate which is a similar calculation used in Activity-based costing. A pre-determined overhead rate is normally the term when using a single, plant-wide base to calculate and apply overhead. Overhead is then applied by multiplying the pre-determined overhead rate by the actual driver units. Any difference between applied overhead and the amount of overhead actually incurred is called over- or under-applied overhead.

## The Need for a Pre-determined Rate

The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed. In recent years increased automation in manufacturing operations has resulted in a trend towards machine hours as the activity base in the calculation.

## How to find the overhead rate

To find the overhead rate, first determine the right basis that will describe the best the behavior of the cost. Then, divide the total budgeted overhead by the basis to calculate the overhead rate:

```  Overhead Rate = (Total budgeted overhead / Basis)
```

## What is the right basis to use to calculate the overhead rate

There are many ways that can be used to determine the right basis for a given order. These bases are:

• Direct Labor Cost: this basis is used when manufacturing is labor-intensive.
• Direct Labor Hours: it is used When workers are paid on the basis of their working hours.
• Prime Cost: the prime cost is used when the factory produces only one kind of product.
• Machine time: this basis is used when manufacturing is mostly automated.

## How to calculate the Overhead budget using the rate

In order to find the overhead rate we will use the same basis that we hahellohosen by multiplying this basis by the calculated rate. For example, if we choose the labor hours to be the basis then we will multiply the rate by the direct labor hours in each task during the manufacturing process.

```           The share of the order of the overhead = Overhead Rate * Resources consumed
```

## Sources

Fundamentals of Cost Accounting. William N. Lanen, Shannon W. Anderson, Michael W. Maher. McGraw-Hill.