predetermined overhead rate

We have previously discussed cost objects and assigning costs to cost objects. One object that is used frequently by job costing.

Job costing is a cost allocation method used by companies that make custom products. Imagine a cabinet maker who makes custom cabinets for homes. Each cabinet is custom built based on measurements made inside the customer’s home. All jobs require different amounts of material, labor, and overhead. Therefore, each job has a unique total cost.

Direct costs are easy to assign to jobs. It is easy to calculate the total cost of direct materials based on the materials used in the job. Companies use job cost sheets to record the cost of materials used on the job.

Direct labor is easy to calculate as we know how much each of the employees earns per hour and how many hours the employees worked on the job. Employees track which jobs they are working on throughout the week so that direct labor costs can be added to the job cost sheets.

Overhead can cause problems for organizations that use job costing. Without allocating overhead to jobs, we do not have an accurate idea of the cost of the job. Since overhead is such a large part of the cost of operating a business, we cannot ignore it. So how do we allocate it?

We could wait until the end of the year, when we know actual numbers but that does not help us determine if our jobs are profitable when they are completed. If we waited until we had all the overhead spending calculated for the year, it would be January of 2017 before we know if jobs completed in 2016 were profitable or not. We can’t wait that long if we want to determine if we are making profit on our jobs.

We could use overhead costs for the current or previous month and apply those costs to the job, but what if our overhead costs vary greatly from month to month. For example, what if we get the annual renewal for our insurance policies in March. Those insurance policies cost $100,000. Is it ethical to allocate that $100,000 only to the jobs that are completed in March or April? No, those costs should be allocated to all jobs completed throughout the year, not just those unlucky customers who happened to place in order with our company in March or April.

If we don’t know the actual costs, how can we allocate overhead fairly to all of our jobs? We are going to use estimates.

Most businesses complete budgets prior to the beginning of each year. These budgets include estimated overhead and estimated activity. We can use those estimates to calculated a rate that we can apply to our jobs. We call this rate the predetermined overhead rate.

Predetermined overhead rate = Estimated Overhead / Estimated Activity

The company can choose any activity it believes will most accurately apply the overhead costs. Most companies use direct labor hours or machine hours to allocate overhead costs.

Example #1

K’s Premier Cabinets uses job costing to calculate the cost of jobs as they are completed. The company estimates that it will have $1,250,000 in overhead costs in 2015. The company believes that employees will work 200,000 hours and that 150,000 machine hours will be used during 2015. Calculate the predetermined overhead rate assuming that the company uses direct labor hours to allocate overhead to jobs.

Predetermined overhead rate is estimated overhead divided by estimated activity. The example states that estimated activity is 200,000 direct labor hours.

$1,250,000 / 200,000 direct labor hours = $6.25 per direct labor hour (don’t forget to label your numbers)

Applying the predetermined overhead rate to jobs

Alright, so we have a rate. Now what?

We must apply the rate to our jobs. The rate from our example above is $6.25 per direct labor hour. How do we apply this to our jobs? Based on the direct labor hours worked on the job. For each direct labor hour worked, we will add $6.25 of overhead to the job.

Applied overhead is overhead added to a job by taking the predetermined overhead rate multiplied by the actual activity. Applied overhead is added to direct materials and direct labor to calculate total job cost.

Total Job Cost = Direct Materials + Direct Labor + Applied Overhead

Every time a job is completed, overhead is applied to the job. The total cost of all the jobs completed over the course of the year is cost of goods sold.

Example #2

K’s Premier Cabinets completes job #322 on July 7. The job used 45 direct labor hours and 30 machine hours. The job consumed $1,800 worth of materials. The average direct labor rate is $18.00 per hour and the company uses the predetermined overhead rate calculated in Example #1. Calculate the total cost of job #322.

There are three components of job cost: direct materials, direct labor and applied overhead.

We are told that direct materials are $1,800.

We must calculate total direct labor cost. Direct labor is a variable cost. Our rate is $18.00 per direct labor hour. Our driver is 45 hours. If we calculate rate x activity, our total direct labor cost for job #322 is:

$18.00 per direct labor hour X 45 direct labor hours = $810

Lastly, we just apply overhead to the job. Overhead is applied by taking our predetermined overhead rate and multiplying it by activity. We are given activity for direct labor hours and for machine hours. Which one do we use? Remember when I said to label your answer? This is precisely why it is so important to label your rate! So what was our rate?

$6.25 per direct labor hour

Therefore, we are going to apply the rate based on direct labor hours.

$6.25 per direct labor hour X 45 direct labor hours = $281.25

We now have the components of job cost. Now to add them up and see what the total cost of the job is.

Direct materials = $1,800
Direct labor = $810
Applied overhead = $281.25
Total job cost = $2,891.25

Final Thoughts

One of the most important pieces of advice I can give you about allocating overhead using a predetermined overhead rate is keeping the terminology straight in your mind.

Estimated overhead is calculated at the beginning of the year before any work begins. Applied overhead is calculated throughout the year as jobs are completed and added to the cost of the jobs.

First calculate your predetermined overhead rate using estimates and LABEL YOUR ANSWER! Then apply overhead to jobs by using the predetermined overhead rate and actual activity.

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Allocating overhead using a predetermined overhead rate

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