Product costing can be extremely helpful in managerial decision-making, and its prime use is related to product costing and job order costing. So, it’s advisable to use different absorption bases for the costing in terms of accuracy. This complexity is driven by different factors, including but not limited to common activity for multi-products and a greater number of supportive activities for the production. If overheads absorbed are less than actual, adjusting entry to increase expense is posted in the accounting record and vice versa.

• Small companies typically use activity-based costing, while large organizations will have departments that compute their own rates.
• Also, if the rates determined are nowhere close to being accurate, the decisions based on those rates will be inaccurate, too.
• It’s useful in cost accounting as product costing can only be obtained once overheads are absorbed in the cost of the product.
• Following are some of the disadvantages of using a predetermined overhead rate.
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What is a predetermined overhead rate?

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Divide budgeted overheads with the level of activity

The predetermined overhead rate is, therefore, usually used for contract bidding, product pricing, and allocation of resources within a company, based on each department’s utilization of resources. A predetermined overhead rate is used by businesses to absorb the indirect cost in the cost card of the business. Further, this rate is calculated by dividing budgeted overheads by the budgeted level of activity. If the predetermined overhead rate calculated is nowhere close to predetermined overhead rate being accurate, the decisions based on this rate will definitely be inaccurate, too.

• When there is a big difference between the actual and estimated overheads, unexpected expenses will definitely be incurred.
• Further, this rate is calculated by dividing budgeted overheads by the budgeted level of activity.
• The predetermined overhead rate is based on the anticipated amount of overhead and the anticipated quantum or value of the base.
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Predetermined Overhead Rate

Hence, this is a compromise on the accuracy of the overall allocation process. On the other hand, the ABC system is more complex and requires extensive administrative work. Overheads have been absorbed in the product cost traditionally using machine and labour hours. However, modern absorption requires the use of multiple bases to enhance the accuracy of the process. Further, the use of sophisticated techniques like the ABC costing system helps enhance the overall accuracy of the costing, quotation, and pricing. Bookkeeping for Chiropractors Company B wants a predetermined rate for a new product that it will be launching soon.

• A predetermined overhead rate is an estimated rate that is used in the absorption of overheads in product costing.
• So, to absorb the indirect cost in the product cost predetermined overhead rate is determined.
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• The predetermined rate of overheads can be calculated by putting the values in the above formula.
• Further, overhead estimation is useful in incorporating seasonal variation and estimate the cost at the start of the project.
• 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 third step is to compute the predetermined overhead rate by dividing the estimated total manufacturing overhead costs by the estimated total amount of cost driver or activity base.

A predetermined overhead rate, also known as a plant-wide overhead rate, is a calculation used to determine how much of the total manufacturing overhead cost will be attributed to each unit of product manufactured. The rate is determined by dividing the fixed overhead cost by the estimated number of direct labor hours. In simple words, complex manufacturing is not limited to the usage of direct material and direct labor, but the use of overheads has increased significantly.

• Budgeted level of activity and other details are used in the calculation of the overhead rate.
• The use of such a rate enables an enterprise to determine the approximate total cost of each job when completed.
• So, the cost of a product in one period may not reflect the cost in another period—for instance, the cost of freezing fish increases in the summer and lowers in the winter.
• Further, it is stated that the reason for the same is that overhead is based on estimations and not the actuals.
• These two factors would definitely make up part of the cost of producing each gadget.
• We can calculate predetermined overhead for material using units to be allocated.
• Following are some of the advantages of using a predetermined overhead rate.

That is, if the predetermined overhead rate turns out to be inaccurate and the sales and production decisions are made based on this rate, then the decisions will be faulty. When there is a big difference between the actual and estimated overheads, unexpected expenses will definitely be incurred. Also, profits will be affected when sales and production decisions are based on an inaccurate overhead rate. Before the beginning of any accounting year, it is determined to estimate the level of activity and the amount of overhead required to allocate the same. At a later stage, when the actual expenses are known, the difference between that allocated overhead and the actual expense is adjusted.

The management can estimate its overhead costs to be $7,500 and include them in the Online Accounting total bid price. The predetermined rate is also used for preparing budgets and estimating jobs costs for future projects. One of the advantages of predetermined overhead rate is that it can help businesses monitor overhead rate.