Why the company prefers the use of the predetermined overhead rate rather than the actual overhead rate?

What is a Predetermined Overhead Rate?

A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year.

Larger organizations may employ a different predetermined overhead rate in each production department, which tends to improve the accuracy of overhead application by employing a higher level of precision. However, the use of multiple predetermined overhead rates also increases the amount of required accounting labor.

How to Calculate a Predetermined Overhead Rate

The predetermined rate is derived using the following calculation:

Estimated amount of manufacturing overhead to be incurred in the period ÷ Estimated allocation base for the period

A number of possible allocation bases are available for the denominator, such as direct labor hours, direct labor dollars, and machine hours.

Example of a Predetermined Overhead Rate

The controller of the Gertrude Radio Company wants to develop a predetermined overhead rate, which she can use to apply overhead more quickly in each reporting period, thereby allowing for a faster closing process. For this calculation, she uses the average manufacturing overhead cost for the past three months, and divides by the estimated amount of machine hours to be used in the current month, based on the most recent production schedule for the period. This results in $50,000 being allocated to inventory in the period. A later analysis reveals that the actual amount that should have been assigned to inventory is $48,000, so the $2,000 difference is charged to the cost of goods sold.

Problems with Predetermined Overhead Rates

There are several concerns with using a predetermined overhead rate, which include are noted below.

Overhead Rate is Not Realistic

Since both the numerator and denominator of the calculation are comprised of estimates, it is possible that the result will not bear much resemblance to the actual overhead rate.

Sales and Production Decisions are Faulty

If sales and production decisions are being made based in part on the predetermined overhead rate, and the rate is inaccurate, then so too will be the decisions.

Variance Recognition Problems

The difference between the actual and predetermined amounts of overhead could be charged to expense in the current period, which may create a material change in the amount of profit and inventory asset reported.

Weak Link to Historical Costs

The use of historical information to derive the amount of manufacturing overhead may not apply if there is a sudden spike or decline in these costs.

By definition, overhead cannot be traced directly to jobs.  Most company use a predetermined overhead rate (or estimated rate) instead of actual overhead for the following reasons:

•A company usually does not incur overhead costs uniformly throughout the year. For example, heating costs are greater during winter months. However, allocating more overhead costs to a job produced in the winter compared to one produced in the summer may serve no useful purpose.

•Some overhead costs, like factory building depreciation, are fixed costs. If the volume of goods produced varies from month to month, the actual rate varies from month to month, even though the total cost is constant from month to month. The predetermined rate, on the other hand, is constant from month to month.

•Predetermined rates make it possible for companies to estimate job costs sooner. Using a predetermined rate, companies can assign overhead costs to production when they assign direct materials and direct labor costs. Without a predetermined rate, companies do not know the costs of production until the end of the month or even later when bills arrive. For example, the electric bill for July will probably not arrive until August. If Creative Printers had used actual overhead, the company would not have determined the costs of its July work until August. It is better to have a good estimate of costs when doing the work instead of waiting a long time for only a slightly more accurate number.

Predetermined overhead rates

Predetermined overhead rates are used to apply overhead to jobs until we have all the actual costs available.  To create the rate,  we use cost drivers to assign overhead to jobs. A cost driveris a measure of activities, such as machine-hours, that is the cause of costs. To assign overhead to jobs, the cost driver should be the cause of the overhead costs, or at least be reasonably associated with the overhead costs. Just as automobile mileage is a good cost driver for measuring the cause of gasoline consumption, machine-hours is a measure of what causes energy costs. By assigning energy costs to jobs based on the number of machine-minutes or hours the job uses, we have a pretty good idea of the energy costs required to produce the job.

Most manufacturing and service organizations use predetermined rates.

To calculate a predetermined overhead rate, a company divides the estimated total overhead costs for a period by an estimated base (or expected level of activity). This activity could be total expected machine-hours, total expected direct labor-hours, or total expected direct labor cost for the period. Companies set predetermined overhead rates at the beginning of the year in which they will use them.  This formula computes a predetermined rate:

Notice how the predetermined rate is based on ESTIMATED overhead and the ESTIMATED base or level of activity.  To apply overhead, we will use the actual amount of the base or level of activity x the predetermined overhead rate.  Again, to apply overhead use this formula:

To demonstrate, assume the accountants at Creative Printers estimated overhead related to machine usage to be $ 120,000 for the year and estimated the machine usage for the year to be 60,000 machine-hours. Thus, the predetermined overhead rate would be calculated as follows:

If we want to apply overhead to jobs.  Job 106 had 875 machine hours and Job 107 had 4,050 machine hours.  The calculation for actual overhead for each job would be:

Actual Overhead

Actual Overhead costs are the true costs incurred and typically include things like indirect materials, indirect labor, factory supplies used, factory insurance, factory depreciation, factory maintenance and repairs, factory taxes, etc.  Actual overhead costs are any indirect costs related to completing the job or making a product.  Next, we look at how we correct our records when the actual and our applied (or estimated) overhead do not match (which they almost never match!).

Why do companies use a predetermined overhead rate rather than actual overhead rate?

Why company uses predetermined overhead rates?

Why do managers use a predetermined manufacturing overhead allocation rate rather than the actual rate to cost jobs?

Why do we use applied overhead instead of actual?