Predetermined Overhead Rates

Definition

Predetermined overhead rates are a method used in cost accounting to allocate overhead costs to products or services. They are calculated by estimating the total overhead costs for a given period and then dividing them by an activity measure, such as direct labor hours or machine hours, to determine a rate that can be applied to each unit of production.

5 Must Know Facts For Your Next Test

1. Predetermined overhead rates are used to allocate overhead costs to products or services in a systematic and consistent manner.
2. The predetermined overhead rate is calculated by dividing the estimated total overhead costs for a given period by the expected level of the activity measure, such as direct labor hours or machine hours.
3. Predetermined overhead rates are typically set at the beginning of the accounting period and remain fixed throughout the period, allowing for better cost control and budgeting.
4. Using predetermined overhead rates can help organizations identify and manage overhead costs more effectively, leading to improved decision-making and profitability.
5. Predetermined overhead rates are an important component of Activity-Based Costing (ABC), as they help to accurately assign overhead costs to specific activities and cost objects.

Review Questions

• Explain the purpose of using predetermined overhead rates in cost accounting.
  • The purpose of using predetermined overhead rates in cost accounting is to allocate overhead costs to products or services in a systematic and consistent manner. By estimating the total overhead costs for a given period and dividing them by an activity measure, such as direct labor hours or machine hours, organizations can establish a rate that can be applied to each unit of production. This helps to accurately assign overhead costs to specific cost objects, leading to improved cost management, decision-making, and profitability.
• Describe how predetermined overhead rates are calculated and how they differ from actual overhead rates.
  • Predetermined overhead rates are calculated by estimating the total overhead costs for a given period and dividing them by an expected level of the activity measure, such as direct labor hours or machine hours. This rate is then applied to each unit of production throughout the period. In contrast, actual overhead rates are calculated after the fact, using the actual overhead costs and the actual activity measure for the period. Predetermined overhead rates are set at the beginning of the period and remain fixed, while actual overhead rates can fluctuate based on changes in overhead costs and activity levels.
• Analyze the role of predetermined overhead rates in the context of Activity-Based Costing (ABC) and how they contribute to more accurate product or service costing.
  • Predetermined overhead rates are an essential component of Activity-Based Costing (ABC), as they help to accurately assign overhead costs to specific activities and cost objects. In ABC, overhead costs are first assigned to various activities based on their consumption of resources, and then the activity-based overhead rates are used to allocate these costs to products or services. By using predetermined overhead rates, organizations can more accurately capture the true cost of producing a product or delivering a service, as the overhead costs are allocated based on the specific activities required, rather than using a single, company-wide overhead rate. This leads to more informed decision-making, improved cost management, and better pricing strategies.

Related terms

Overhead Costs: Overhead costs are indirect costs that cannot be directly attributed to the production of a specific product or service, such as rent, utilities, and administrative expenses.

Activity-Based Costing (ABC): Activity-Based Costing is a costing methodology that assigns overhead costs to products or services based on the activities required to produce them, rather than using a single overhead rate.

Cost Allocation: Cost allocation is the process of assigning overhead costs to various cost objects, such as products, services, or departments, based on a predetermined allocation method.