For a successful business, it is important to understand your company’s finances. Predetermined overhead rate (POHR) is an important parameter related to manufacturing industry. In easier terms, it is a type of allocation rate used to estimate cost of manufacturing over a certain time period. It may sound technical but it is a powerful yet simple tool used by businesses to allocate indirect costs.
In this article we are going to discuss What is Predetermined Overhead Rate(POHR), the information required to calculate a predetermined overhead rate, an example of POHR, common mistakes to avoid, problems with POHR.
What is Predetermined Overhead Rate?
In accounting terms predetermined overhead rate is the allocation rate applied for indirect manufacturing costs involved in production of a certain product.
Predetermined Overhead Rate(POHR) is used to approximate the future manufacturing costs. This POHR is calculated by the accountants by dividing total estimated manufacturing overhead cost by the allocation base(also referred to as the activity driver). Some of the commonly used activity drivers or allocation bases are:
- Machine Hours: Machine hours are a measuring unit that is used to measure the operational time of a machine over a certain time period.
- Cost of Material Used: As its name suggest it is the sum of the cost of material used during the production of a product/services.
- Cost of Labour Hours: It is also known as the labour hours rate. It includes labour wages, overhead and other expenses related to labour.
Why Businesses Use It?
Companies can’t wait till the year’s end to calculate the actual cost of the product because it makes it impossible for the company to price the product accurately throughout the whole year. Calculating Predetermined Overhead Rate (POHR) provides certain benefits.
- Consistency: POHR helps to level out any fluctuations in overhead costs. For example, during the winter heating bills are higher but the cost of product remains stable.
- Timely Information: Businesses can estimate job profitability as soon as it is completed.
- Simplified Record Keeping: It creates a standardized way to charge overhead for specific projects.
Rate Formula Used
Businesses use the predetermined overhead rate formula to calculate the Predetermined Overhead Rate (POHR):
- Predetermined Overhead Costs= Estimated manufacturing overhead costs/Estimated allocation base
Let’s look at every component of predetermined overhead rate formula in detail
How Businesses Calculate Predetermined Overhead Rate?
To calculate Predetermined overhead you have to divide pre calculated manufacturing overhead cost by the activity driver or allocation base. For instance, if activity is in machine hours then you should divide the overhead cost by calculated machine hours.
How to Determine The Estimated Manufacturing Overhead Costs?
Mainly manufacturing overhead costs are the expenses related to overhead costs resulting from producing goods. Generally, manufacturing overhead costs include:
- Maintenance of the factory
- Maintain regular factory supplies
- Facility maintenance
Sometimes accountants include employee wages in the list. Note: only include employees’ wages if they are involved in the production of goods. Some examples are:
- Factory supervisors
- Maintenance workers
- Cleaning crews.
Do not add the wages of office employees. Add them when you determine all the company’s manufacturing costs to get the total.
Determine the Allocation Base
As we have already mentioned, accountants may use machine hours, direct labour hours, and costs in an allocation base or activity driver. Assume a business is focused on auto repair, then the accountant has to use labour hours in the calculation to find the hours required by a labourer to complete the job.
If the business is manufacturing some physical goods, accountants should determine the number of hours the machine uses during the allocation base or the activity period.
Calculate Predetermined Overhead Rate
Till now, we have determined all the required parts of the equation. Now let’s calculate Predetermined Overhead Rate (POHR) by dividing Estimating manufacturing costs by the allocation base or activity driver.
Assume a company has $40000 of manufacturing overhead costs and 7,000 machine hours. The company’s predetermined overhead cost for this instance will be $5.72PU (per unit).
Example of Predetermined Overhead Rate
Let’s assume there is a company named XUV that manufactures a product EFG. XUV uses labour hours to assign the manufacturing overhead cost. The accountant calculated the total overhead expenses as $335,000 and estimated the labour hours as $3200. With the help of the Rate Formula calculate the predetermined overhead cost. The answer will be 335,000/ 3200=104.6875 by using the rate formula.
So, the predetermined overhead rate is 104.7 per direct labour hour.
Mistakes to Avoid During the Calculation of POHR
Some of the common mistakes that people usually make during the Predetermined Overhead Rate:
1. Allocation Base
One of the common mistakes made by businesses and accountants is that they use the wrong allocation Base. When you use an activity driver that does not correlate with your overhead costs, then your product cost will be inaccurate. For instance, if you use direct labour hours as your allocation base but your overhead costs relate more to running the machine, then your calculation will be incorrect.
Solution: carefully examine what really relate with your overhead costs. If you are unsure about the correct allocation base, then track various matrices for a few months to see which activity driver best correlates.
2. Fully Rely On the Past Year’s Numbers Without Any Adjustment
With time, market changes, process improves, and cost fluctuates. Using the previous year’s overhead rates without considering any changes can lead to pricing errors.
Solution: Review your overhead rate quarterly and make adjustments if needed. If the condition changes significantly, then recalculate the overhead rate.
3. Use Single Rate for Various Departments.
If your business consists of multiple departments with different overhead structures, then a single predetermined rate can cause errors.
Solution: for different departments or cost centres, calculate separate rates. For example, your assembly area can correlate more with direct labour hours, while your machining area correlates more with machine hours.
Practical Approach For Predetermined Overhead Rate
Here are some practical approaches that can be used to determine overhead rates in a manufacturing business:
- Gather Data: Collect information from previous overhead costs and the chosen allocation base. Search for patterns and trends.
- Make a Realistic Projection: Based on your previous data and upcoming plans, determine your overhead costs and allocation base for the upcoming period.
- Calculate Rate: With the help of the given formula, calculate the rate.
- Apply the Calculated Rate: Use the calculated rate to assign the overhead cost to product or services as produced.
- Compare Your Estimated Cost With the Actual Cost: At the end of the period, compare your predetermined estimated overhead cost with the actual overhead cost.
- Learn and Adjust: Apply whatever you learn to improve your estimates for the next period.
Conclusion
The Predetermined Overhead Rate (POHR) are not a realistic rate, but are predetermined number calculated through a given formula. This is very useful for production-related companies as it aids them in setting prices for their products and services and ensures that their expenses don’t go overboard. We hope that this article will be useful for you. You can also check out our other articles to get knowledge about other account related Querries.