POHR = Total Estimated Overhead Costs ÷ Total Estimated Allocation Base
The predetermined rate enables overhead costs to be applied to products as they are manufactured.
Understanding the Inputs
Total Estimated Overhead Costs
The sum of all indirect costs expected to be incurred in a production process for a given period (e.g., factory rent, utilities, supervisor salaries, maintenance, depreciation). These are costs that cannot be directly traced to a specific product.
Total Estimated Allocation Base
The total expected quantity of the activity that drives overhead costs. Common bases include direct labor hours, machine hours, direct labor cost, or direct material cost. Choose the base that has the strongest correlation with overhead costs.
Unit for Allocation Base
The unit of measure for your allocation base (e.g., "hours", "dollars", "units"). This helps clarify how the overhead rate will be applied.
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**Overhead** refers to all indirect costs associated with running a business, particularly manufacturing a product. These costs cannot be directly traced to a specific unit of output (unlike direct labor or direct materials) but are essential for production.
Examples of Overhead Costs
Overhead costs include:
Factory rent and property taxes.
Utilities (electricity, gas) for the plant.
Supervisory salaries and maintenance wages.
Depreciation of factory equipment.
For accurate inventory valuation and pricing decisions (cost accounting), these indirect costs must be systematically assigned (allocated) to every product unit manufactured during the period. Failure to allocate overhead leads to understating the true cost of inventory.
The Predetermined Overhead Rate Formula
Companies typically use a **Predetermined Overhead Rate (POHR)** to allocate costs. This rate is calculated *before* the start of the fiscal period to allow management to set prices and estimate costs throughout the year without waiting for final, actual overhead figures.
The Calculation Identity
The POHR is calculated by dividing the estimated total overhead costs for the coming year by the estimated total volume of the chosen allocation base (cost driver):
POHR = Estimated Total Overhead Cost / Estimated Total Volume of Allocation Base
Applying the Rate (Costing)
Once the POHR is established (e.g., 20 dollars per machine hour), it is applied to each job or product unit based on how much of the allocation base that unit consumes:
Overhead Applied = POHR * Actual Amount of Allocation Base Used
Selecting the Allocation Base (Cost Driver)
The **Allocation Base** (or Cost Driver) is the factor that most closely correlates with the incurrence of overhead costs. Choosing the correct base is crucial for ensuring the allocated overhead is fair and accurate.
Common Cost Drivers
Direct Labor Hours (DLH): Used when human labor is the primary source of complexity and time. Overhead costs like supervision and indirect labor correlate well with DLH.
Machine Hours (MH): Used when production is highly automated. Overhead costs like equipment depreciation, maintenance, and utilities correlate better with machine time.
Direct Material Dollars: Less common, used in processes where material handling and purchasing overhead is high.
The Causation Principle
The best allocation base is the one that demonstrates a **cause-and-effect relationship** with the overhead costs. If machine time causes higher maintenance and electricity costs, machine hours should be the cost driver. Using an irrelevant base (e.g., allocating machine maintenance based on direct labor hours) leads to inaccurate product costing and skewed pricing decisions.
Overhead Absorption and Product Costing
**Overhead Absorption** is the process of applying the estimated overhead costs to the work in process (WIP) inventory, becoming part of the final inventory cost on the Balance Sheet.
The Full Product Cost
The total manufacturing cost assigned to a unit of inventory is the sum of all three cost components:
Total Product Cost = Direct Materials + Direct Labor + Applied Overhead
This full cost is used for calculating the cost of goods sold (COGS) on the Income Statement and setting the minimum acceptable selling price for products.
Under- or Over-Applied Overhead
Because the POHR is based on estimates, the total overhead applied to inventory during the year rarely matches the total **actual overhead costs** incurred. This difference is called the under- or over-applied overhead. This discrepancy must be adjusted at the end of the period, usually by adjusting the COGS figure.
Activity-Based Costing (ABC) vs. Traditional Allocation
The POHR method (traditional costing) is simple but often inaccurate for complex environments. **Activity-Based Costing (ABC)** offers a more precise, multi-driver approach.
Traditional Costing Flaw (Single Rate)
The traditional method often uses a single, plant-wide POHR. This assumes that all products consume overhead resources at the same rate, which is false in modern, diverse manufacturing facilities (e.g., a simple product may require few setups, while a custom product requires many setups and inspections).
ABC Methodology (Multiple Drivers)
ABC refines allocation by assigning costs based on the specific activities that consume overhead (e.g., machine setup, quality inspection, engineering design). ABC uses a separate rate and base for each activity, providing highly accurate product costs, particularly for low-volume, complex products that consume disproportionate overhead.
Conclusion
The **Predetermined Overhead Rate (POHR)** is the essential cost accounting tool used to assign all indirect manufacturing expenses to product inventory. It is calculated by dividing estimated total overhead costs by the chosen **allocation base** (cost driver).
Accurate overhead allocation is vital for determining the true **Total Product Cost**, ensuring correct inventory valuation, and setting profitable sales prices. While the traditional single-rate system is simple, sophisticated firms often rely on **Activity-Based Costing (ABC)** for greater precision in complex production environments.
Frequently Asked Questions
Common questions about overhead rate allocation and cost accounting
What is a predetermined overhead rate?
A predetermined overhead rate is an estimated rate used to apply manufacturing overhead costs to products or jobs. It's calculated at the beginning of the period using estimated overhead costs and estimated activity levels. This allows companies to assign overhead costs as products are being produced rather than waiting until the end of the period.
Why use a predetermined overhead rate instead of actual overhead?
Using predetermined rates allows for timely product costing during the period, better job cost tracking, and more accurate pricing decisions. Waiting for actual overhead at the end of the period would delay product costing and decision-making. The difference between applied and actual overhead is recorded and allocated at period-end.
How do I choose the best allocation base?
The best allocation base is one that has a strong correlation with overhead costs. Machine hours work well when overhead is primarily driven by machine usage. Direct labor hours are appropriate when overhead is labor-intensive. Consider your production process and which cost driver most accurately represents the consumption of overhead resources.
What happens if actual overhead differs from applied overhead?
At the end of the period, the difference between actual and applied overhead is called underapplied (if actual > applied) or overapplied (if applied > actual) overhead. This variance can be allocated to cost of goods sold and inventory accounts, or closed directly to cost of goods sold, depending on the materiality of the amount.
How often should I recalculate the overhead rate?
Overhead rates are typically recalculated annually based on budgeted costs and activity levels. However, if there are significant changes in production processes, cost structure, or business conditions during the year, it may be appropriate to revise the rate mid-year for better accuracy.
Can I use different allocation bases for different cost pools?
Yes, this approach is known as activity-based costing (ABC). Different cost pools may use different allocation bases that better reflect their specific cost drivers. For example, quality inspection costs might be allocated based on number of inspections, while machine maintenance might use machine hours.
What's the difference between plant-wide and department rates?
A plant-wide rate uses one single rate for the entire facility. Departmental rates use separate rates for different departments or cost centers, which can provide more accuracy when departments have different overhead structures and cost drivers. Departmental rates are more complex but offer better cost allocation precision.
How does overhead rate allocation affect product pricing?
The overhead rate directly impacts the cost assigned to each product, which affects pricing decisions. If the rate is too low, products may be underpriced and unprofitable. If too high, products may be overpriced and non-competitive. Accurate overhead allocation ensures prices cover all costs including indirect manufacturing expenses.
What costs should be included in overhead?
Manufacturing overhead includes all indirect production costs that cannot be directly traced to specific products, such as factory rent, utilities, depreciation of manufacturing equipment, indirect materials and labor, maintenance, quality control, and production supervision. These costs are necessary for production but not part of direct materials or direct labor.
Can overhead rates be used for service businesses?
Yes, service businesses can use overhead rates to allocate indirect costs to jobs or clients. Instead of manufacturing overhead, they allocate costs like office rent, administrative salaries, and support functions. The allocation base might be billable hours, service units, or revenue, depending on the nature of the service business.
Summary
Overhead rate allocation assigns indirect manufacturing costs to products based on consumption of cost drivers.
Common bases include machine hours and direct labor hours; choose the base most correlated with overhead.
Under/over-applied overhead is adjusted at period-end to ensure accurate cost of goods sold.
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