Predetermined Overhead Rate

The predetermined overhead rate divides budgeted overhead by an estimated activity base—such as direct labour hours, machine hours, or units produced—before the period begins. It yields a rate applied to each job or unit, smoothing volatile overhead costs and enabling rapid product costing.

Why predetermined rates exist

Overhead—factory rent, utilities, depreciation, supervisory salaries—is real and substantial, but it does not attach neatly to individual units like materials or labour do. Firms cannot know the total overhead incurred until the period closes and bills arrive. Yet managers need product costs immediately, both to set prices and to assess job profitability. A predetermined rate solves this problem by dividing the expected overhead by an activity level, locking a rate in advance.

For example, a machine shop budgets $120,000 in overhead for the year and anticipates 10,000 machine hours of production. The predetermined rate is $120,000 ÷ 10,000 = $12 per machine hour. Each job is charged $12 for every machine hour it consumes, regardless of whether actual overhead that month was higher or lower.

Choosing the activity base

The activity base—the denominator in the rate calculation—must correlate with how overhead actually varies. A factory with expensive automated machinery may use machine hours because setups, utilities, and maintenance tie to machine time. A labour-intensive service firm might use labour hours. A batch manufacturer might use setup count if most overhead cost clusters around changeovers rather than run time. The better the base matches the overhead-driving activity, the more accurate the applied cost.

This is where cost driver logic enters. Accountants analyse overhead expenses, looking for the primary lever that causes costs to move. That becomes the basis for the rate. Choosing poorly—say, applying overhead to units produced in a job with vastly different machine intensities—will distort product profitability.

Application during the period

Once the rate is set, every job or product is tagged with an amount of the activity base (e.g., 50 machine hours). The overhead applied to that job is simply the rate multiplied by the activity consumed: 50 hours × $12/hour = $600. The journal entry accumulates this applied overhead into work-in-process inventory, alongside actual materials and labour costs.

This happens in real-time or at least monthly, not at year-end. Products can be costed and sold as they complete, giving management timely insights into profitability and allowing faster billing.

Normal costing: the typical framework

Predetermined overhead rates sit at the heart of normal costing, a widespread hybrid method. Normal costing uses actual materials and actual labour costs but substitutes the predetermined overhead rate for actual overhead. This yields costs that are quick and reliable. In contrast, standard costing goes further: it pre-sets expected costs for materials, labour, and overhead all together, enabling variance analysis. And pure actual costing waits for true overhead to be known, delaying reporting but giving exact figures—rarely done in practice because the delay is too costly.

The variance at period-end

At the close of the accounting period, actual overhead is tallied. Almost always, it differs from applied overhead (the predetermined rate times the actual activity that occurred). This gap is the over- or under-applied overhead. An underapplication means actual overhead exceeded applied; overapplication means applied exceeded actual. Most firms close this variance to cost of goods sold, adjusting the reported profit.

If the variance is large, it signals that either the predetermined rate was wildly off-target or actual activity swung dramatically. Either way, the next period’s rate will be adjusted or the activity forecast revised.

Multiple predetermined rates

Large firms with diverse product lines or plants often compute separate predetermined rates for different areas or cost pools. A manufacturer might have one rate for the machining department (based on machine hours) and a different rate for the assembly department (based on labour hours). This granularity improves accuracy, as each rate tracks the overhead that truly drives costs in that area. Some advanced systems use activity-based costing logic, with multiple rates tied to specific overhead drivers like inspections, setups, or material handling.

Practical adjustments

In periods of high inflation or volatile input costs, firms sometimes recompute the rate quarterly or mid-year rather than annually, using revised forecasts. And some introduce seasonal adjustments if the business is strongly cyclical. But the discipline is the same: set the rate early, apply it consistently, and review the variance at close.

Limitations and refinements

A single predetermined rate assumed constant efficiency. If the shop runs machines at 80 per cent capacity one month and 120 per cent the next, the rate still applies the same overhead per hour, potentially misrepresenting fixed overhead absorption. Fixed overhead is spread thin in low-volume months and compressed in high-volume months. More sophisticated variance analysis breaks this apart: quantity variances (did we produce as many units as expected?), efficiency variances (did we use more labour hours than standard?), and spending variances (did overhead exceed budget?). Each tells a different story.

Also, the predetermined rate assumes the chosen activity base is measurable and reliable. If the time-tracking system is sloppy or machine-hour counters are inconsistent, the applied overhead becomes garbage. Data hygiene matters.

See also