A predetermined overhead rate is used by businesses to absorb the indirect cost in the cost card of the business. It’s a budgeted rate that is calculated by budgeted inputs. Further, this rate is calculated by dividing budgeted overheads by the budgeted level of activity.
However, if there is a difference in the total overheads absorbed in the cost card, the difference is accounted for in the financial statement. Let’s understand the detailed perspective of the concept along with steps.
The business has to incur different types of expenses for the manufacturing of the products. These expenses include direct material, direct labour, direct overheads, and indirect overheads etc. The direct cost is easily allocated in the product cost as we need to allocate the quantity in line with the usage.
However, absorption of indirect cost is something technical and complex. 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.
It’s also important to note that budgeted figures in calculating overhead rates are used due to seasonal fluctuation/expected changes in the external environment. So, actual cost is not used to calculate an overhead rate.
The following formula is used to calculate the predetermined rate of overhead,
Once an overhead rate is calculated using the given formula, it’s absorbed in the cost card of the business using the actual level of the activity. At the end of the accounting period, the actual indirect cost is obtained and compared with the absorbed indirect.
If the absorbed cost is more than the actual cost, an adjusting entry is passed to reduce the expenses. On the other hand, if the actual cost is more, an adjusting entry is passed to record the remaining cost in the business’s income statement.
Let’s understand the steps in calculating the predetermined overhead rate.
1- Estimate budgeted overheads
The first step is to estimate total overheads to be incurred by the business. This can be best estimated by obtaining a break-up of the last year’s actual cost and incorporating seasonal effects of the current period. Further, inflationary and demand-related factors also need to be assessed.
Detailed cost analysis helps to estimate the cost of overheads with accuracy. Further, customized input from different departments can be obtained to enhance the accuracy of the budget.
2- Assess the level of activity
To estimate the level of activity, sales and production budget can be used. However, there is a strong need to constantly update the production level depending on the seasonal fluctuations and the factor affecting the demand of the product.
3- Divide budgeted overheads with the level of activity
It’s a simple step where budgeted/estimated cost is divided with the level of activity calculated in the third stage. The resultant output of the process is called predetermined overheads. It’s called predetermined because both of the figures used in the process are budgeted.
Example of predetermine overhead rate and basis of absorption
Suppose following are the details regarding indirect expenses of the business.
|Basis of absorption
|Cleaning and maintenance expense
|Per square foot
|Kitchen expense (service center)
|No of staff
|No of machines hours
|Indirect labor cost
|No of labor hours
The business is labor-intensive, and the total hours for the period are estimated to be 10,000.
If the business used the traditional costing/absorption costing system, the total overheads amounting to $26,000 will be absorbed using labor hours. That’s because the business has a labor incentive environment.
However, the problem with absorption/traditional costing is that we have to ignore individual absorption bases and absorb all overheads using a single level of activity. 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. However, the prime advantage of using the ABC system is greater accuracy.
It’s important to note that if the business uses the ABC system, the individual activity is absorbed on a specific basis. For instance, cleaning and maintenance expenses will be absorbed on the basis of the square feet as shown in the table above.
Characteristics of the predetermined overhead rate
It’s a completely estimated amount that changes with the change in the level of activity. In addition to this, some companies use a single overhead rate.
For instance, it has been the traditional practice to absorb overheads based on a single base. For instance, a business with a labor incentive environment absorbs the overhead cost with the labor hours. On the other hand, the business with the machine incentive environment absorbs overhead based on the machine hours.
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.
However, the business needs to consider if the associated cost of implementing ABC costing (multiple absorptions) is cost-effective. It’s because administrative cost increases with the implementation of ABC costing.
Uses of calculating the predetermined overhead rate
Businesses normally face fluctuation in product demand due to seasonal variations. Fixed overheads are expected to increase/decrease per unit in line with the seasonal variations. 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.
Hence, the fish-selling businesses need to monitor the seasonal variations and adjust the cost pattern of the products. The use of predetermined overheads effectively incorporates the cost effects of seasonal variations in the product cost and price.
In addition to this, project planning can also be done with the use of an overhead rate. It’s because it’s an estimated rate and can be predicted at the start of the project.
On the other hand, if the business wants to use actual overheads, it has to wait for the end of the month and get invoices in hand. So, it may not be a good idea with perspective to effective business management.
Predetermined overhead is an estimated rate used by the business to absorb overheads in the product cost, and it’s calculated by dividing overheads by the budgeted level of activity. Both figures are estimated and need to be estimated at the start of the project/period.
Traditionally, overheads have been absorbed in the product cost based on a single basis of apportionment. For instance, in a labor-intensive environment, labor hours were used to absorb overheads. On the other hand, the machine hours were used to absorb overheads in a machine incentive environment.
However, this practice does not result in fair allocation of the overheads. So, a more precise practice of overhead absorption has been developed that requires different and relevant bases of apportionment.
Further, overhead estimation is useful in incorporating seasonal variation and estimate the cost at the start of the project. This helps in matters related to costing, pricing, and quotations.
However, since absorbed overheads are estimated, there is a need to adjust the difference between budgeted and actual overheads in the financial statement at the end of the accounting period or when the actual bill/invoice is received.
Frequently asked questions
What’s the cost impact of implementing the ABC costing system?
Implementation of ABC requires identification and record maintenance for various overheads. This record maintenance and cost monitoring is expected to increase the administrative cost. So, the businesses need to do a cost-benefit analysis before implementing the ABC system of costing.
What’s included in fixed overheads?
Fixed overheads include but are not limited to the following,
- Rent expense for the production/administrative facility.
- Depreciation on the fixed assets utilized in production.
- Salaries of the support departments – like canteen and procurement.
- Cost of insurance.
What is complex overhead absorption?
Complex overhead absorption is when multiple absorptions are required to allocate the cost of the support function. For instance, kitchen expenses first need to be allocated to the procurement department (a support department). It’s then further allocated to the departments that use the procurement facility.