Ralph’s Machine Tools Company assigns manufacturing overhead costs based on direct labor and applies this rate to job orders.
Ralph’s Machine Tools Company had an estimated manufacturing overhead cost of $15,000 for the upcoming year.
The direct labor hours it expects for the upcoming year are 2,000.
This information can be used to calculate the predetermined overhead rate.
Estimated manufacturing overhead cost/Estimated total units in the allocation base = Predetermined overhead rate
The predetermined overhead rate for Ralph’s Machine Tools Company is:
$15,000/2,000 hours = $7.50 per direct labor hour.
The formula used to compute the predetermined overhead rate uses estimates.
This means that the overhead that is applied to jobs or products is different than the actual overhead from the product or job.
The adjustment made to eliminate this difference at the end of the period is called the disposition of over or underapplied overhead.
Example 2
Dorothy’s Hat Company computed a predetermined overhead rate based on annual machine hours.
At the start of 2021, Dorothy’s Hat Company estimated that the total manufacturing overhead cost for the year would be $320,000, and the total machine hours would be 50,000 hours.
The company actually had $300,000 in total manufacturing overhead costs for the year, and the actual machine hours used were 53,000.
Now, compute the predetermined overhead rate for 2021.
Determine the manufacturing overhead costs that Dorothy should have applied to her hats.
Answer
Predetermined overhead rate:
Estimated manufacturing overhead cost/Estimated machine hours
$320,000/50,000 hours = $6.40 per machine hour
Manufacturing overhead applied to products:
Actual machine hours used x Predetermined overhead rate
53,000 * $6.40 = $339,200
Example 3
The operating and cost data are given next for three separate companies.
The companies use different allocation bases when calculating their predetermined overhead rates.
Company 1Company 2Company 3Direct Labor Hours95,000120,000150,000Machine Hours140,00080,000110,000Direct Materials Cost$800,000$600,000$900,000Manufacturing Overhead Cost$1,000,000$860,000$1,110,000Company 1: Machine hours
Company 2: Direct materials cost
Company 3: Direct labor hours
Next, calculate the predetermined overhead rate for the three companies above.
Answer
Company 1
Estimated manufacturing overhead cost/Estimated machine hours
$1,000,000/140,000 hours = $7.14
Company 2
Estimated manufacturing overhead cost/Estimated direct materials cost
$860,000/$600,000 = $1.43
Company 3
Estimated manufacturing overhead cost/Estimated direct labor hours
$1,110,000/150,000 = $7.40
Multiple Predetermined Overhead Rates
The predetermined overhead rate as calculated above is a plant-wide overhead rate or a single predetermined overhead rate.
This rate is generally only used by small companies.
Large companies will typically have a predetermined overhead rate for each production department.
Using multiple predetermined overhead rates is more complicated and takes more time, but it is generally thought to be more accurate than using a single predetermined overhead rate for the entire plant.
Example 4
The Holiday Candy Company uses a job-order costing system and calculates different predetermined overhead rates for its molding and packaging departments.
These are the estimates the company computed at the start of 2021.
Molding Department
Direct labor hours: 5,000
Machine hours: 25,000
Manufacturing overhead cost: $150,000
Direct labor cost: $50,000
Packaging Department
Direct labor hours: 24,000
Machine hours: 7,000
Manufacturing overhead cost: $528,000
Direct labor cost: $240,000
The molding department bases its overhead rate on its machine hours. Whereas the packaging department bases its overhead rate on labor hours.
Now, calculate the predetermined overhead rate for the departments listed above.
Answer
Molding Department
The overhead rate for the molding department is computed by taking the estimated manufacturing overhead cost and dividing it by the estimated machine hours.
Overhead rate for the molding department = estimated manufacturing overhead cost/ estimated machine hours
$150,000/25,000 hours = $6 per machine hour
The overhead rate for the molding department is $6 per machine hour.
Packaging Department
The overhead rate for the packaging department is calculated by taking the estimated manufacturing overhead cost and dividing it by the estimated direct labor cost.
Estimated overhead for the finishing department = estimated manufacturing overhead cost/ estimated direct labor cost
$528,000/$240,000 = $2.20 per dollar of direct labor
The overhead rate for the packaging department is $2.20 per dollar of direct labor.
This means the manufacturing overhead cost would be applied at 220% of the company’s direct labor cost.
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