How the predetermined overhead rate is calculated?

Costs are also said to be direct or indirect relative to a cost object. The material and labor costs of production that are physically and conveniently traceable to products are direct costs. All other costs incurred in the production area are indirect and are referred to as manufacturing overhead.

The extensive activity required to convert raw materials into finished goods distinguishes manufacturers and service companies from retailers. This conversion process necessitates that all factory costs be accumulated and reported as product costs under accrual accounting.

A predetermined overhead rate is calculated by dividing the upcoming period’s budgeted overhead costs by a selected level of activity. (Budgeted overhead costs at various levels of activity are shown on a flexible budget. Predetermined overhead rates eliminate the problems caused by delays in obtaining actual cost data, make the overhead allocation process more effective, and allocate a uniform amount of overhead to goods or services based on related production efforts.

The activity base chosen to compute a predetermined overhead rate should be logically related to cost changes and be a direct causal factor of that cost (a cost driver) rather than simply a predictor. Units of output are a valid measure only if the company produces a single product.

When a company uses a predetermined overhead rate, underapplied or over- applied overhead results at the end of the year. This amount (if insignificant) should be closed to Cost of Goods Sold or (if significant) allocated among Work in Process Inventory, Finished Goods Inventory, and Cost of Goods Sold.