Definition: A predetermined overhead rate is an estimated ratio of overhead costs established before an accounting period that are based on another variable and used to allocate costs during the production process. In other words, a predetermined rate is an estimated amount of overhead costs that managerial accountants calculate an activity base will use. This rate is then used to allocate the overhead costs to the production process based on the rate and the corresponding activity base.
What Does Predetermined Overhead Rate Mean?
Yes, I know it sounds confusing. : ) Basically, it’s a way for management to estimate overhead costs in the production process in the planning and budgeting stages before the year begins. Let’s take a look at an example.
Cost accountants want to be able to estimate and allocate overhead costs like rent, utilities, and property taxes to the production processes that use these expenses indirectly. Since they can’t just arbitrarily calculate these costs, they must use a rate.
The predetermined overhead rate formula is calculated by dividing the total estimated overhead costs for the period by the estimated activity base.
Take direct labor for example. Assume that management estimates that the labor costs for the next accounting period will be $100,000 and the total overhead costs will be $150,000. The predetermined rate would equal 1.5. This means that for every dollar of direct labor cost a production process uses, it will use $1.50 of overhead costs.
Now management can estimate how much overhead will be required for upcoming work or even competitive bids. For instance, assume the company is bidding on a job that will most likely take $5,000 of labor costs. The management can estimate its overhead costs to be $7,500 and include them in the total bid price. The predetermined rate is also used for preparing budgets and estimating jobs costs for future projects.