Introduction
A Predetermined Overhead Rate (POR) is an overhead absorption rate computed in advance of the operations period. Typically calculated from budgeted figures, this rate helps businesses allocate overhead costs to products or job orders, providing insights into financial planning and cost management.
Historical Context
The concept of predetermined overhead rates emerged alongside the development of cost accounting in the early 20th century. As manufacturing processes and business operations became more complex, it became crucial to allocate indirect costs accurately to ensure proper pricing and profitability analysis.
Calculation and Formula
The Predetermined Overhead Rate is calculated using the following formula:
Predetermined Overhead Rate (POR) = Estimated Total Overhead Costs / Estimated Total Activity Base
Where:
- Estimated Total Overhead Costs might include indirect labor, indirect materials, utilities, and other overhead expenses.
- Estimated Total Activity Base could be direct labor hours, machine hours, or any other base relevant to production.
Application
- Budgeting and Planning: The POR allows businesses to allocate estimated overhead costs to products in advance, facilitating better financial planning and control.
- Cost Allocation: Helps in assigning overhead costs to job orders or production processes.
- Variance Analysis: Assists in comparing budgeted costs to actual costs, identifying variances and areas for improvement.
Examples
Consider a manufacturing company with the following budgeted data for the year:
- Estimated Overhead Costs: $500,000
- Estimated Machine Hours: 25,000 hours
The Predetermined Overhead Rate would be:
POR = $500,000 / 25,000 hours = $20 per machine hour
If a job uses 100 machine hours, the overhead allocated would be:
Overhead Allocated = POR * Actual Machine Hours Used
= $20 * 100 hours
= $2,000
Importance and Applicability
- Consistency: Ensures consistent allocation of overhead costs across different products and periods.
- Simplification: Simplifies the accounting process by using a uniform rate for various accounting periods.
- Control: Enhances control over financial and operational performance by facilitating variance analysis.
Considerations
- Accuracy: The accuracy of the POR depends on the accuracy of the budgeted figures.
- Adjustments: Necessary adjustments may be required at year-end to align with actual costs.
- Selection of Activity Base: The choice of activity base (e.g., machine hours, labor hours) significantly influences the rate and should align with the nature of operations.
Related Terms
- Absorption Costing: A method of costing that includes all manufacturing costs – both fixed and variable.
- Direct Costs: Costs that can be directly attributed to a specific cost object, such as a product or job.
- Indirect Costs: Costs that are not directly attributable to a specific cost object and need to be allocated.
Interesting Facts
- The use of predetermined rates dates back to the early industrial revolution when companies started to face increased complexity in their production processes.
- Predetermined overhead rates are pivotal in lean manufacturing and Six Sigma methodologies.
Inspirational Stories
Consider the example of a small manufacturing business struggling with profitability. By implementing a predetermined overhead rate system, the business was able to better allocate costs, resulting in improved financial insights, more accurate pricing, and ultimately increased profitability.
Famous Quotes
- “The goal is to turn data into information, and information into insight.” – Carly Fiorina
- “Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.” – Diane Garnick
Proverbs and Clichés
- “Fail to plan, plan to fail.”
- “You can’t manage what you can’t measure.”
Expressions, Jargon, and Slang
- Overhead Allocation: The process of distributing overhead costs to products or job orders.
- Budgeted Costing: Estimating and planning costs in advance.
FAQs
Q1: Why is the predetermined overhead rate important?
- The predetermined overhead rate is crucial for budgeting, planning, and controlling costs. It helps in consistent cost allocation and enhances financial visibility.
Q2: What happens if the actual overhead costs differ from the predetermined rate?
- Variances between actual and predetermined rates are analyzed at the end of the period. This can lead to adjustments in financial statements and future budgeting processes.
References
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
- “Management and Cost Accounting” by Colin Drury.
- “Financial & Managerial Accounting” by Carl S. Warren, James M. Reeve, and Jonathan Duchac.
Summary
The Predetermined Overhead Rate is a fundamental concept in cost accounting that ensures the accurate allocation of overhead costs to products or job orders. By facilitating better financial planning and control, it plays a crucial role in a company’s budgeting, variance analysis, and overall financial health. Understanding its computation and application is essential for accountants, financial planners, and business managers alike.
