Predetermined overhead rate;Guide Complete.

A predetermined overhead rate is an allocation rate that is used to apply an estimated cost of manufacturing overhead to either products or job orders.Our discussion in this chapter has assumed that the actual overheads for an accounting period have been allocated to the products. However, the calculation of overhead rates based on the actual overheads incurred during an accounting period causes a number of problems. First, the product cost calculations have to be delayed until the end of the accounting period, since the overhead rate calculations cannot be obtained before this date, but information on product costs is required quickly if it is to be used for monthly profit calculations and stock valuations or as a basis for setting selling prices.

Predetermined overhead rate;Guide Complete.

Secondly, one may argue that the timing problem can be resolved by calculating actual overhead rates at more frequent intervals, say on a monthly basis, but the objection to this proposal is that a large amount of overhead expenditure is fixed whereas activity will vary from month to month, giving large fluctuations in the overhead rates.

Consider Example 4.2. The fixed overheads for XYZ Ltd are 1240 000 per annum, and monthly production varies from 4000 to 10 000 hours. The monthly overhead rate for fixed overhead will therefore fluctuate as follows:

  • Monthly overhead 120000   120 000
  • Monthly production 4000 hours   10 000 hours
  • Monthly overhead rate f5 per hour £2 per hour

Fixed overhead expenditure remains constant each month, but monthly production fluctuates because of holiday periods and seasonal variations in demand. Consequently the overhead rate varies from 12 to £5 per hour. It would be unreasonable for a product worked on in one month to be charged at £5 per hour for overhead and an identical product worked on in another month to be charged at only 12 per hour.

Such fluctuating overhead rates are not representative of typical, normal production conditions. Management has committed itself to a specific level of fixed costs in the light of foreseeable needs for beyond one month. Thus, where production fluctuates, monthly overhead rates may be volatile. Furthermore, some costs such as repairs, maintenance and heating are not incurred evenly throughout the year. Therefore, if monthly overhead rates are used, these costs will not be allocated fairly to units of output.

For example, heating costs would be charged only to winter production. An average, annualized rate based on the relationship of total annual overhead to total annual activity is more representative of typical relation-ships between total costs and volume than a monthly rate. What is required is a normal product cost based on average long-term production rather than an actual product cost, which is affected by month-to-month fluctuations in production volume. Taking these factors into consideration, it is preferable to establish an estimated overhead rate based on annual estimated overhead expenditure and activity. Consequently the procedure outlined in the previous sections for calculating departmental overhead rates should be based on estimated activity levels and not actual activity levels.

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