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Predetermined overhead rate in manufacturing

Predetermined Overhead Rate

why do companies use a predetermined overhead rate rather than actual manufacturing
overhead costs to apply overhead to jobs?

Explain underapplied and overapplied overhead and tell about the adjustment that is
made at the end of the period.

What is a plantwide overhead rate? Why are multiple overhead rates, rather than
plantwide rates used by some companies?

What happens to overhead rates based on direct labor when automated equipment
replaces direct labor? 

Predetermined overhead rate 2
Predetermined overhead rate are applied on production or manufacturing overheads as a way of
calculating the average cost that the actual overhead expenses costs. Using the predetermined
overhead rates ensures that the accountants follow the accounting policies under GAAP as
products are assigned overhead costs as the products are manufactured. It’s difficult to apply the
actual manufacturing overhead costs for each product as every product must be assigned a
portion of utility consumed by a predetermined overhead rate to ensure accountability and easy
calculation of all the overhead costs in the manufacturing process. Using the actual
manufacturing rate would be laborious and time consuming if all the costs incurred in the
manufacturing process have to be allocated and apportioned correctly. Predetermined overhead
rates are preferred to actual manufacturing rates as they facilitate faster decision making and easy
cost tracking (Banker, Hwang and Mishra, 2002).
Companies have different ways of costing the manufacturing overhead but the underlying
concepts is that all the raw materials used and the production overheads must all be accounted
for when the products have been manufactured. When the initial estimates of the overhead costs
used differ from the actual costs or expenses used then the results are said either as over or
underapplied overheads. When the estimates are less than the actual then the costs have been
underapplied but when they are more than the actual then the costs have been overapplied. When
a company uses a predetermined overhead rate that is based on the company’s full capacity
allocation while the plant is operating at reduced or less capacity, the overhead applied would be
underapplied. It happens when a company’s actual activities are less than what the company’s
predetermined overhead rate is actually based on.

Predetermined overhead rate 3
Underapplied overheads are adjusted by adding the differences between the actual overheads and
the estimates while the overapplied overhead differences are subtracted from the actual cost of
the goods that have been sold (Balakrishnan, 2011).
Plantwide overhead rate is a single overhead rate that is used to allocate a company’s
manufacturing overhead costs to all departments in the company. Multiple overhead rates are
utilized to instead of plantwide overhead to ensure appropriate or the right quantity overheads are
allocated to various cost centers. It is recommended where some departments are machine
intensive while others are labor intensive.
When automated equipment is used as a base to allocate overhead rates instead of direct labor,
direct labor the overhead costs increases while direct labor costs decreases. It also results in the
increment of the predetermined overhead rate especially if the rates are pegged on direct labor.

Predetermined overhead rate 4
Balakrishnan, R. (2011) Journal of Management Accounting Research editor’s report. Journal of
Management Accounting Research (23): 331-33
Banker, R. D., Hwang. I. and Mishra. B.K. (2002) Product costing and pricing under long-term
capacity commitment. Journal of Management Accounting Research (14): 79-97.

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