A predetermined overhead rate sets the manufacturing overhead cost of a work in process. The rate is determined before production even begins, meaning that it is not necessarily an accurate representation of the actual cost of overhead for a project. Nevertheless, many managers prefer to use a predetermined overhead rate because of advantages in the way of consistency.
The predetermined overhead rate is based on the estimated total overhead costs to the estimated total activity base. The overhead costs include items such as electricity, administrative salaries and wages, rent and other costs applied to the business as a whole. The activity base refers to costs associated with the actual project, such as the labor cost of employees directly engaged in the project and raw materials.
The predetermined overhead rate is calculated by simply dividing the estimated overhead expense by the estimated activity base. For example, if overhead expenses are estimated to be $5 million for a particular period and the activity cost of a manufacturing project over that period amounts to $20 million, the predetermined overhead rate would be 1-to-4, meaning that for every dollar spent on the direct costs of a project, management should allocate 25 cents in overhead costs.
The primary advantage of a predetermined overhead rate is to smooth out seasonal variations in overhead costs. These variations are to a large extent caused by heating and cooling costs, which, while high in the summer and winter months, are relatively low in the spring and fall. The actual cost of a particular project, however, should be evaluated independently of the season in which the project is completed.
Another advantage of a predetermined overhead rate is that it can be used to plan for the cost of future projects. If a company wants to use the actual overhead rate to calculate the cost of a project, it is unable to do so until after the project has been completed and true costs are known. Estimating the cost relative to the activity base allows managers to budget for future projects.