predetermined overhead rate

A workshop knows exactly what the walnut for a table costs and exactly how many labor hours went into it — those are easy to trace. But what about the rent, the electricity, the factory manager's salary, the depreciation on the saw? These overhead costs are shared by every job and don't arrive neatly attached to any one of them. Worse, you often only learn the true total at year-end, yet you need to price and cost jobs all year long. The solution is to estimate a rate in advance and apply it as you go. That estimated rate is the predetermined overhead rate.

The predetermined overhead rate is computed before the period begins as estimated total manufacturing overhead divided by the estimated total amount of an allocation base (such as direct labor hours, machine hours, or direct labor cost). For example, if a factory expects 600,000 dollars of overhead and 40,000 machine hours next year, its rate is 15 dollars per machine hour. Then, as each job runs, overhead is applied to it by multiplying this 15-dollar rate by the actual machine hours that job used. The rate is set once, in advance, and used uniformly all period — that predictability is the whole point.

This rate matters because it lets a business assign overhead to products promptly and consistently, instead of waiting until year-end when the real numbers are known. It underlies product pricing, inventory valuation, and profitability analysis throughout the year. The unavoidable catch: because both the numerator (estimated overhead) and the denominator (estimated activity) are forecasts, the applied overhead will almost never exactly equal actual overhead — leaving an under- or over-applied balance to clean up. And if the chosen allocation base doesn't really drive overhead, the rate can systematically mis-cost products, which is the very problem activity-based costing was invented to fix.