A predetermined overhead rate is an overhead charging rate set before a period starts, computed as budgeted overhead divided by the budgeted volume of a chosen allocation base, and used to charge overhead to jobs and units while the period is still running. The same figure appears in UK material as an overhead absorption rate.
Predetermined marks the rate as set in advance from budgeted figures, which is what separates it from an actual overhead rate computed after the close. The tax rules name the method built on it: a burden rate method allocates an appropriate amount of indirect costs to property produced or acquired for resale using predetermined rates that approximate the actual amount of indirect costs incurred by the taxpayer during the taxable year (Treasury Regulation 1.263A-1(f)(3)(i)(A)).
How the Rate Is Computed and Applied
Two formulas do the whole job, and each reaches for a different figure.
Predetermined overhead rate = budgeted overhead / budgeted activity in the allocation base
Applied overhead = predetermined overhead rate x actual activity in the baseBudgeted overhead is the indirect cost the pool is expected to hold for the period. The allocation base is the activity overhead gets charged in proportion to, usually machine hours, direct labor hours or direct labor dollars, and budgeted activity is the volume of it the period expects to consume. Actual activity is what a job really used, the only input that moves from job to job once the rate is set.
Both inputs are budgeted because of when the answer is needed. An overhead figure has to sit on a job while the job is still open, and the period’s real indirect cost is not known until the books close.
Inventory costing on the books narrows the denominator for the fixed part of the pool. The allocation of fixed production overheads to the costs of conversion is based on the normal capacity of the production facilities, the production expected over a number of periods or seasons under normal circumstances (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5, as amended by FASB Statement No. 151). The actual level of production may be used if it approximates normal capacity.
Nothing requires one rate for the whole operation. A plant-wide rate, a rate per department and a rate per cost pool all run the same arithmetic on differently drawn pools. The contrast with a rate per activity belongs to activity based costing.
Where a Firm Sets and Uses the Rate
The rate is set in the budget cycle, before the year it governs. It then surfaces on job costing, where it puts an overhead figure on work still in progress, and in inventory valuation, where the applied amount is part of what sits on the balance sheet. At year end the gap between what the rate applied and what overhead actually cost, the under or over-applied burden, has to be disposed of, and that true-up has a book answer and a different tax answer, both in costing overheads.
What a Predetermined Overhead Rate Is Confused With
Applied Overhead and Actual Overhead Incurred
The rate is not the charge, and neither one is the cost. The rate is an amount per unit of the base, applied overhead is what that rate put onto a cost object, and actual overhead incurred is what the pool really cost. A report that just says overhead has not said which of the three it means. How the gap between applied overhead and actual overhead incurred splits belongs to 2-way variance analysis.
A Standard Overhead Rate
A predetermined rate and a standard cost method sit one subsection apart in the same regulation, and they are not the same method. A standard cost method allocates direct and indirect costs to property produced through preestablished standard allowances, without reference to costs actually incurred during the taxable year (Treasury Regulation 1.263A-1(f)(3)(ii)(A)). So a predetermined rate aims at the actual figure and expects to miss it slightly, while a standard says what the cost ought to be, and the gap it opens is a variance to explain, the sense of the word set out in budgeted.
What Is the Formula for Predetermined Manufacturing Overhead Rate?
The formula does not change, only the pool narrows. Budgeted manufacturing overhead divided by the budgeted volume of the allocation base is the rate. Manufacturing overhead means the production layer of overhead, so factory rent, power, depreciation on production equipment and production supervision sit in the pool, and selling costs do not. General and administrative costs are the hard case, and costing overheads works through the book and tax tests that decide where they land.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm’s own reviewer grades real work through a trial task before any client file moves.
