What is a Predetermined Factory Overhead Rate?

A predetermined factory overhead rate, also known as a predetermined overhead allocation rate or predetermined overhead rate, is a predetermined or estimated rate used to allocate or apply indirect manufacturing overhead costs to products or cost objects. It is calculated before the actual costs are known and serves as a basis for allocating overhead costs to products or jobs during a specific accounting period.

Here are some key points about predetermined factory overhead rates:

  1. Calculation: The predetermined factory overhead rate is calculated by dividing the estimated total overhead costs for a specific period by a predetermined allocation base or cost driver. The allocation base is chosen based on the most significant factor that drives the incurrence of overhead costs, such as direct labor hours, machine hours, or direct labor costs.
  2. Estimation: The estimation of total overhead costs and the choice of the allocation base are based on historical data, industry standards, and management’s judgment. It involves forecasting the expected overhead costs and the anticipated level of activity for the period.
  3. Application: Once the predetermined factory overhead rate is calculated, it is used to allocate indirect manufacturing overhead costs to products or cost objects. The rate is multiplied by the actual usage of the allocation base for each product or job to determine the allocated overhead cost.
  4. Adjustments: At the end of the accounting period, the actual overhead costs incurred are compared to the estimated overhead costs used in the predetermined rate calculation. Any difference, known as underapplied or overapplied overhead, is typically adjusted by making a journal entry to account for the variance.

The use of a predetermined factory overhead rate provides a practical way to allocate overhead costs to products or cost objects without waiting for the actual costs to be determined. It allows for better planning, cost control, and decision-making by providing a more timely and accurate reflection of the overhead cost impact on each product or job.

It’s important to note that the predetermined factory overhead rate is based on estimates and assumptions. Actual overhead costs may differ from the estimates, resulting in variances that need to be accounted for at the end of the period. Regular monitoring and analysis of the overhead allocation process help ensure the accuracy of the predetermined rates and provide insights into the cost behavior within the manufacturing process.

Caroline Grimm

Caroline Grimm is an accounting educator and a small business enthusiast. She holds Masters and Bachelor degrees in Business Administration. She is the author of 11 books and the creator of Accounting How To YouTube channel and blog. For more information visit: https://accountinghowto.com/about/

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