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20.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production

Why Predetermined Overhead Rate?​

Manufacturing overhead cannot be easily traced to specific jobs, so it must be allocated. However, we don't know the actual overhead until the end of the period. Therefore, we use a predetermined overhead rate to apply overhead to jobs as they are worked on.

Advantages:

  • Apply overhead during the period (not wait until year-end)
  • More timely cost information
  • Better job costing during the period
  • Standard practice in job order costing

Calculating Predetermined Overhead Rate​

Formula: Predetermined Overhead Rate = Estimated Total Manufacturing Overhead ÷ Estimated Activity Base

Activity Base Options:

  • Direct labor hours
  • Direct labor cost
  • Machine hours
  • Direct materials cost
  • Units produced

Most Common:

  • Direct labor hours (most common)
  • Direct labor cost
  • Machine hours

Example: Direct Labor Hours as Base​

Estimated Data:

  • Estimated total overhead: €60,000 per year
  • Estimated direct labor hours: 4,000 hours per year

Predetermined Overhead Rate: €60,000 ÷ 4,000 hours = €15 per direct labor hour

Application: If a job uses 10 direct labor hours: Applied overhead = 10 hours × €15 = €150

Example: Direct Labor Cost as Base​

Estimated Data:

  • Estimated total overhead: €60,000 per year
  • Estimated direct labor cost: €80,000 per year

Predetermined Overhead Rate: €60,000 ÷ €80,000 = 0.75 or 75% of direct labor cost

Application: If a job has €200 direct labor cost: Applied overhead = €200 × 75% = €150

Example: Machine Hours as Base​

Estimated Data:

  • Estimated total overhead: €60,000 per year
  • Estimated machine hours: 2,000 hours per year

Predetermined Overhead Rate: €60,000 ÷ 2,000 hours = €30 per machine hour

Application: If a job uses 5 machine hours: Applied overhead = 5 hours × €30 = €150

Applying Overhead to Jobs​

Process:

  1. Calculate predetermined overhead rate (at beginning of period)
  2. As jobs are worked on, apply overhead using the rate
  3. Record applied overhead to Work in Process
  4. At period end, compare applied to actual overhead

Journal Entry to Apply Overhead:

Work in Process - Job #101     €150
    Manufacturing Overhead                    €150
To apply overhead to Job #101 (10 hours × €15/hour)

Actual vs. Applied Overhead​

Actual Overhead:

  • Real overhead costs incurred during the period
  • Recorded as costs are incurred
  • Examples: Actual rent paid, actual utilities, actual depreciation

Applied Overhead:

  • Overhead allocated to jobs using predetermined rate
  • Based on estimates
  • May differ from actual

Example:

  • Actual overhead for period: €62,000
  • Applied overhead for period: €60,000
  • Difference: €2,000 (underapplied)

Choosing an Activity Base​

Considerations:

  • Cause-and-Effect: Base should cause overhead to be incurred
  • Measurability: Base should be easy to measure
  • Cost: Cost of tracking base should be reasonable
  • Accuracy: Base should provide accurate allocation

Common Choices:

  • Direct Labor Hours: Good when labor-intensive
  • Direct Labor Cost: Good when wage rates vary
  • Machine Hours: Good when machine-intensive
  • Direct Materials: Less common, used when materials drive overhead

Luxembourg Compliance Note​

In Luxembourg:

  • Predetermined overhead rates are acceptable for internal costing
  • Rates should be reasonable and based on estimates
  • Actual overhead should be tracked
  • Differences (underapplied/overapplied) must be handled
  • Consider Luxembourg-specific overhead costs
  • PCN accounts support overhead tracking

Think It Through​

Why do we use a predetermined overhead rate instead of waiting until the end of the period to know actual overhead? What are the advantages and potential disadvantages?