Predetermined overhead rate calculator

A plant that expects $480,000 of overhead and 40,000 direct labor hours sets a predetermined rate of $12.00 per hour. It works 38,500 hours, so it applies $462,000 to production while actually spending $492,000. The $30,000 difference is underapplied overhead, 6.5% of what was charged. The rate also decides what individual jobs cost: at $12 per labor hour, a machine-heavy job carries $240 of overhead when a departmental rate would give it $1,260.

The calculator sets the rate on the base you choose, applies it to two jobs, compares a plantwide rate with departmental rates, shows the year-end over- or underapplied amount, and splits it two ways: all to cost of goods sold, or prorated across inventory and cost of goods sold.

Who reaches for this

Overhead is the cost of running a factory that cannot be traced to a single product: rent, depreciation, supervision, utilities, maintenance and indirect labor. Actual overhead is not known until the period ends, but jobs have to be costed while they are being made. The solution is to set a rate before the period begins, using estimates, and apply it as work is done.

Three steps make up the method. Before the year starts, divide estimated overhead by the estimated activity in the base you have chosen. During the year, charge each job the rate times the activity it actually uses. At year-end, compare the overhead applied with the overhead actually incurred and close the difference. The calculator follows those steps in order. It adds a comparison of plantwide and departmental rates, because the choice of rate structure changes what jobs cost more than almost any other decision in the system.

The fixed overhead rate and the volume variance on the standard cost variance calculator come from the same idea. That page splits the year-end difference into spending, volume and efficiency pieces. This page starts one step earlier, with how the rate is set.

The rate is only as good as its two inputs. Estimated overhead comes from the budget: every indirect manufacturing cost for the period, including the fixed costs that do not change with output and the variable costs that do. Estimated activity is a forecast of how much of the allocation base the plant will use. In the running example the plant budgets $480,000 of overhead and expects 40,000 direct labor hours, so the rate is $12.00 per hour.

Which activity level?

The denominator is the estimate that people argue about. Three levels are in use, and each gives a different rate. Expected activity is what the plant thinks it will actually work this year. Normal capacity is the average level over several years, which smooths out good and bad years. Practical capacity is the most the plant could run with normal allowances for maintenance and breaks.

A larger denominator lowers the rate, charges less overhead to each unit, and leaves more unapplied at year-end. That leftover amount is the cost of capacity the plant paid for and did not use, and it is a real number, not an accounting artifact. Reporting standards address the choice. IAS 2 and the U.S. GAAP inventory guidance direct that fixed production overhead be allocated on the basis of normal capacity, and that overhead left unallocated because of abnormally low production be recognized as an expense in the period rather than added to inventory. Variable overhead is allocated on actual use. The practical point is that whichever level you use, use it consistently and explain the leftover.

The allocation base is the measure that overhead follows. The best base is the one that actually drives overhead, so that a job that uses more of it really does cause more overhead. Four bases are common.

The base changes job costs dramatically when jobs use it in different proportions. Take the two jobs in the calculator. Job A is machine-heavy: 20 labor hours and 100 machine hours. Job B is labor-heavy: 100 labor hours and 10 machine hours. The same $480,000 of overhead gives a $12.00 rate on 40,000 labor hours, a $16.00 rate on 30,000 machine hours, and $0.48 per dollar of labor on $1,000,000 of direct labor cost.

The two bases give opposite answers. Labor hours load Job B with overhead and nearly ignore Job A, and machine hours do the reverse. Neither is a mistake, since they rest on different assumptions about what drives cost. The question is which assumption fits the plant. If most of the $480,000 is machine depreciation and power, machine hours are right and the labor-hour rate is subsidizing machine-heavy work at the expense of labor-heavy work. Automation makes this shift more common each year, which is why labor-based rates are often out of date in plants that have added equipment.

A simple test for the base

Three checks show whether a base fits. List the overhead items and ask what makes each one grow: more people, more machine time, more batches, or nothing at all. Then lay twelve months of overhead beside the monthly total of each candidate base, and see which one moves with it. Finally, cost a few real jobs on the base and ask the people who run the floor whether the overhead each job carries feels right. A base that fails the third check is usually wrong even when the arithmetic is clean.

Do not expect a perfect match. Much overhead is fixed, so it does not track any base month to month. The goal is a base that ranks jobs correctly, so that the job that puts the most demand on the plant carries the most overhead, and not one that predicts each month’s bill.

A plantwide overhead rate pools all overhead into one cost pool and applies it with one base. It is simple, cheap to run and easy to explain. It is accurate only when every product uses overhead in about the same proportion to the base, which is often not true once a plant has more than one kind of department.

Departmental rates

A departmental rate gives each department its own pool and its own base. In the example, machining carries $360,000 of overhead over 30,000 machine hours, a rate of $12.00 per machine hour, and assembly carries $120,000 over 40,000 labor hours, a rate of $3.00 per labor hour. Job A is charged 100 machine hours at $12 and 20 labor hours at $3, or $1,260. Job B is charged 10 machine hours at $12 and 100 labor hours at $3, or $420.

Adding materials of $1,800 and labor of $500 to Job A gives a plantwide cost of $2,540 and a departmental cost of $3,560. A shop pricing from the plantwide figure would quote the machine-heavy job about $1,020 too low and the labor-heavy one $780 too high. It would win the jobs it loses money on and lose the ones it could make money on, a pattern that shows up as thin margins on complex work and lost bids on simple work.

Activity-based rates

Activity-based costing goes further. It groups overhead by activity, such as machine setups, inspections, material handling and engineering changes, and assigns each pool by its own driver. A $100,000 setup pool divided by 500 setups gives $200 per setup, so a small batch that needs three setups carries $600 whatever its labor or machine hours. It fits plants with diverse products, small and large batches, and overhead that is a large share of cost. The price is complexity: more pools, more drivers to measure and more to maintain.

A practical rule is to move from one rate to several when a plantwide rate produces costs that management does not believe, when departments differ sharply in overhead intensity, or when overhead is large enough that a mistake moves margins. If every job flows through the same departments in similar proportions, a plantwide rate is fine.

A job cost sheet collects direct materials, direct labor and applied overhead. Job A uses $1,800 of materials and $500 of labor. On the plantwide rate its 20 labor hours apply $240 of overhead, for a total of $2,540. The overhead is estimated, not measured, so the job cost is a predetermined cost, and it is the number that goes into work in process and, once the job ships, cost of goods sold.

Applying overhead as work is done rather than at year-end means jobs can be quoted, invoiced and margin-checked while they are open. It also means inventory is valued during the year at a full cost that includes overhead, which financial reporting requires. The price of that convenience is the difference at year-end between applied and actual overhead. If production ran lower than the estimate, the plant applied less than it spent. If overhead spending ran higher than the budget, the same happened.

The same idea in a contracting or service business

Overhead rates are not only for factories. A contractor with $150,000 of yearly overhead, covering the office, insurance, vehicles and estimating time, and 6,000 billable labor hours has an overhead rate of $25.00 per billable hour. A job that takes 200 hours has $5,000 of overhead to recover before it earns a profit. A crew that bills 5,000 hours instead of 6,000 recovers only $125,000, and the $25,000 shortfall is underapplied overhead in everything but name.

The lesson carries over: the rate depends on an estimate of volume, and volume that misses the estimate leaves overhead unrecovered. Small firms that never compute the rate often price at direct cost plus a guessed markup and find at year-end that the markup did not cover overhead. The calculator works for a service business by entering billable hours as the base and the yearly overhead budget as the estimate.

When the rate turns out to be wrong

If mid-year results show the estimate was far off, for instance a lost customer cuts volume by a quarter, the rate can be revised for the rest of the year. The revision applies to work from that point on. It does not restate jobs already costed, and the two rates should be documented so that jobs before and after the change are not compared without adjustment. Small misses are better left to the year-end difference.

Overhead applied through the year is rarely equal to overhead actually incurred. The difference is defined here as actual minus applied. A positive result is underapplied, and a negative result is overapplied. Sources disagree on the sign, since some define it as applied minus actual, so check which convention any table you read is using. The plant in the example has $492,000 of actual overhead and $462,000 applied, so $30,000 is underapplied.

Why it happens

Two causes account for the difference. Actual overhead can differ from the budget, which is a spending problem. Actual activity can differ from the estimate, which is a volume problem. In the example, overhead was $12,000 over the $480,000 budget. Activity was 1,500 hours below the 40,000 estimate, so the plant applied 1,500 × $12.00 = $18,000 less than it would have at the planned volume. The two effects add up to $30,000.

These are the fixed overhead spending and volume variances from the standard costing view. If some of the overhead is variable, and it follows the base, the split changes, and the standard cost variance calculator handles that with separate variable and fixed rates. What matters here is the direction of the fix. A spending problem calls for cost control. A volume problem calls for a better forecast or a decision about capacity, and no amount of cost control repairs it.

Size matters too. A difference of 1% to 2% of applied overhead is often treated as noise. At 6.5% the example is worth a look, and a difference that keeps the same sign year after year says the estimates are biased. Check the pattern, not only the amount.

At year-end the overhead control account holds the actual overhead as debits and the applied overhead as credits. The balance is the underapplied or overapplied amount, and it has to be closed. Two treatments are common.

Close it to cost of goods sold

For a small difference, or one that relates mostly to goods already sold, debit cost of goods sold for $30,000 and credit manufacturing overhead for $30,000. This is the simple method, and it reduces income by the full amount. Overapplied overhead is closed the other way: debit manufacturing overhead and credit cost of goods sold.

Prorate it

For a material difference, spread it among the accounts that received the overhead: work in process, finished goods and cost of goods sold. Suppose the ending balances are $200,000, $300,000 and $1,500,000. Their shares are 10%, 15% and 75%, so the $30,000 splits $3,000, $4,500 and $22,500. Inventory then carries closer to actual cost and cost of goods sold takes only its share. A more exact version prorates on the applied overhead in each account, and some companies use it for that reason.

Which to use is a matter of materiality and policy. When the difference is small compared with cost of goods sold, most companies close it directly. When it is large, proration keeps inventory and income from being distorted. Whatever the choice, apply it consistently and disclose it if reporting requires.

Two practical questions come up once the rate is running. The first is why the rate is set for a year and not a month. The second is what the hours are that it gets multiplied by.

One annual rate

Fixed overhead does not follow the calendar. A plant with $40,000 of fixed overhead a month that works 2,000 labor hours in January and 5,000 in June would have a monthly rate of $20.00 in January and $8.00 in June. The same job would cost $12 more per labor hour to make in winter. A single annual rate charges every job the same overhead per hour, and the seasonal swings show up in the year-end difference where they belong, not in job costs.

Normal costing and standard costing

Normal costing applies overhead at the predetermined rate times actual activity, and uses actual materials and labor. Standard costing applies overhead at the rate times the standard hours allowed for the actual output, and uses standard materials and labor. The two give different applied amounts when workers are faster or slower than the standard. If the plant made 10,000 units at 0.5 standard hours each, the allowed hours are 5,000 for that output. In another example, 37,000 standard hours allowed against 38,500 actual hours apply $444,000 under standard costing and $462,000 under normal costing. The $18,000 gap is the efficiency effect, and the standard cost variance calculator shows it as the variable overhead efficiency variance.

Job quotes lean on the overhead rate more than on any other single number. Take a shop that quotes cost plus 25%. On the plantwide rate, Job A costs $2,540 and is quoted at $3,175. Its true departmental cost is $3,560, so the quote is $385 below cost. Job B costs $4,600 on the plantwide rate and is quoted at $5,750, while its departmental cost of $3,820 would support a quote of $4,775 and a competitor pricing from that figure would undercut the shop by nearly $1,000.

A wrong overhead rate quietly moves margin between jobs. The company’s total margin can look fine while some work loses money and other work is priced out of the market. Check the rate against how overhead is actually consumed before relying on it for quotes. The markup vs. margin calculator converts a cost-plus percentage into a margin, and the contribution margin calculator shows what each job adds after variable costs, since fixed overhead spread by a rate does not change with any one job.

Next, see how the year-end difference splits into variances on the standard cost variance calculator, or what a cost structure does to profit with the break-even point page.