.svg){kind=icon}
How to Calculate a Predetermined Overhead Rate (OH): A Step-by-Step Guide
Introduction
A predetermined overhead rate (OH) is a critical calculation used by businesses to allocate manufacturing overhead costs to products or services. This rate helps in budgeting, pricing, and financial planning by estimating overhead costs in advance rather than waiting for actual figures. Understanding how to calculate this rate ensures accurate cost estimation, leading to better decision-making and profitability.
In this guide, we’ll walk through a step-by-step process for calculating the predetermined overhead rate, its importance, and best practices for accuracy.
What Is a Predetermined Overhead Rate?
The predetermined overhead rate is an estimated rate used to allocate overhead costs to products or jobs. It is typically established at the beginning of an accounting period and is based on projected costs and activity levels. This rate helps businesses assign indirect costs efficiently rather than waiting for actual data at the end of a period.
The formula for the predetermined overhead rate is:
Predetermined Overhead Rate = Estimated Total Overhead Cost / Estimated Total Activity Base
The activity base is typically measured in direct labor hours, direct labor costs, or machine hours, depending on the nature of the business.
Why Should You Care?
Suppose, if you're supplying auto parts, industrial equipment, or specialized tools, you've got overhead costs coming at you from every direction. Your warehouse isn't paying for itself, and those forklifts aren't running on hopes and dreams. Having a solid grip on your overhead rate lets you:
- Price your products so you're making money, not just breaking even
- Figure out if that new product line is worth the investment
- Keep your business healthy when you're serving both B2B and B2C customers
- Know exactly how much it costs to keep the lights on in each of your locations
Step 1: Add Up Your Estimated Overhead Costs
First, you need to total up all your expected overhead costs for the coming year. Here's what you should include:
- Warehouse costs (rent, utilities, maintenance)
- Equipment costs (forklifts, packing stations, shipping equipment)
- Labor costs that aren't direct (warehouse managers, customer service team)
- Sales team compensation
- Insurance and property taxes
- IT systems and software
- Quality control costs
For example, let's say you're running a medium-sized auto parts distribution business. Your total estimated overhead might look something like this:
- Warehouse rent and utilities: $180,000
- Equipment maintenance: $45,000
- Indirect labor: $250,000
- Sales team: $200,000
- Insurance and taxes: $75,000 IT and systems: $50,000
- Total estimated overhead: $800,000
Step 2: Pick Your Allocation Base
The allocation base is the factor you’ll use to spread overhead costs across jobs or products. The most common bases include:
- Direct labor hours
- Machine hours
- Units produced
- Direct labor cost
- Square footage
Pro tip: Pick something that makes sense for your business. If you're mostly moving boxes around a warehouse, direct labor hours might be your best bet. If your operation is heavily automated, machine hours could work better.
Step 3: Estimate Your Allocation Base
Now, forecast how many labor hours, machine hours, or total labor costs you expect over a given period. This number should be as realistic as possible.
Let's say you're going with direct labor hours. Calculate how many hours you expect your team to work directly on products next year:
20 workers × 40 hours × 50 weeks = 40,000 direct labor hours
Step 4: Do the Math
Now for the easy part. The formula is:
Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Allocation Base
For example, if your total estimated overhead costs for the year are $80,000 and you expect 40,000 machine hours, your predetermined overhead rate would be: $20 per direct labor hour.
Making This Work in Real Life
For Multiple Locations
If you're running several warehouses, calculate separate rates for each location. The rent in Atlanta isn't the same as Chicago, and your overhead rate should reflect that.
For B2B and B2C Operations
Running both B2B and B2C? You might need separate rates for each. B2C usually involves more picking and packing time for smaller orders, while B2B might have more equipment usage for bulk orders.
Seasonal Businesses
If your business has busy and slow seasons (looking at you, construction suppliers), consider calculating different rates for different times of the year. Your overhead doesn't disappear in the slow season, but your allocation base sure does.
Common Mistakes to Avoid
1. Using the Wrong Allocation Base
If you pick an allocation base that doesn't actually correlate with how overhead costs are incurred, your product costs will be distorted. For example, if you use direct labor hours but most of your overhead costs relate to running machines, you'll miscalculate.
Fix it: Step back and look at what really drives your overhead costs. If you're not sure, try tracking different metrics for a few months to see which one correlates best.
2. Relying on Last Year's Numbers Without Adjusting
Markets change, processes improve, and costs fluctuate. Using last year's overhead rate without considering changes can lead to pricing mistakes.
Fix it: Review your estimates quarterly and adjust as needed. Don't be afraid to recalculate if conditions change significantly.
3. Using a Single Rate for Different Departments
If you have multiple departments with very different overhead structures, a single predetermined rate can cause serious distortions.
Fix it: Consider calculating separate rates for different departments or cost centers. For example, your assembly area might use direct labor hours while your machining area uses machine hours.
Bringing It All Together: A Practical Approach
Here's a practical, no-nonsense approach to implementing predetermined overhead rates in your business:
- Gather your data: Collect information on past overhead costs and your chosen allocation base. Look for patterns and trends.
- Make reasonable projections: Based on your historical data and future plans, estimate your overhead costs and allocation base for the coming period.
- Calculate your rate: Divide estimated overhead by the estimated allocation base.
- Apply the rate: Use this rate to assign overhead costs to products or services as they're produced.
- Compare actual to estimated: At the end of the period, compare your actual overhead costs to what you applied using the predetermined rate.
- Learn and adjust: Use what you learned to improve your estimates for the next period.
When to Get More Sophisticated
For some businesses, a single predetermined overhead rate works perfectly fine. But as you grow, you might need to level up your approach. Consider moving to multiple overhead rates if:
- Different products use resources in significantly different ways
- You have distinct departments with their own overhead structures
- You're noticing certain products seem consistently over or under-costed
- You're making important pricing or product mix decisions based on profitability
How Flxpoint Can Help Reduce Overhead Costs
- Automation of Manual Tasks: By automating processes like order entry, inventory updates, and supplier communications, Flxpoint reduces the need for manual labor, thereby lowering labor costs.
- Efficient Inventory Management: Flxpoint enables seamless integration with multiple suppliers, allowing you to manage orders and inventory from one centralized dashboard. This reduces the need for extensive warehousing and associated costs.
- Scalability Without Significant Overhead: As your business grows, Flxpoint allows you to scale operations without substantial investments in additional infrastructure or labor, keeping overhead costs in check.
By leveraging Flxpoint's comprehensive platform, businesses can effectively reduce overhead costs, leading to improved profitability and operational efficiency.
Request a Demo Today
Overhead Cost FAQ
How often should I recalculate my predetermined overhead rate?
Most businesses recalculate their rate annually as part of their budgeting process. However, if you experience significant changes in your operations or costs, you might want to recalculate mid-year. For example, if you add a new production facility, experience dramatic changes in utility costs, or significantly change your production methods, it makes sense to revisit your overhead rate.
What happens if my actual overhead differs from my estimate?
This is completely normal and expected! At the end of the accounting period, you'll have a difference (called a variance) between your applied overhead (using the predetermined rate) and your actual overhead costs. If you applied more overhead than you actually incurred, that's an over-applied overhead. If you applied less, that's an under-applied overhead.
These variances are typically handled in one of two ways:
1. They can be allocated proportionally to Work in Process, Finished Goods, and Cost of Goods Sold accounts
2. They can be closed directly to Cost of Goods Sold if the amount isn't material
Can I use different overhead rates for different departments?
Absolutely! In fact, as your business grows more complex, using departmental overhead rates often gives you more accurate product costing. For example, if you have both a cutting department with expensive machinery and a hand-finishing department that's labor-intensive, you might use machine hours for the first and direct labor hours for the second.
What's the most common mistake businesses make with predetermined overhead rates?
The biggest mistake is choosing an allocation base that doesn't actually correlate with how overhead costs are incurred. For example, if you allocate based on direct labor hours but most of your costs are related to running automated equipment, your product costs will be distorted. The key is to select an allocation base that has a logical relationship with your overhead costs.
How detailed should I get with my overhead categories?
This depends on the size and complexity of your business, but a good rule of thumb is to strike a balance between accuracy and practicality. For most small to medium businesses, categorizing overhead into 5-10 major categories (rent, utilities, indirect labor, etc.) is sufficient. Larger operations might break this down further into 15-20 categories for better tracking and control.
Does ecommerce have different overhead considerations than traditional retail?
Absolutely. E-commerce businesses typically have different overhead structures - they might have higher technology and website maintenance costs but lower physical store expenses. For e-commerce operations, allocation bases might include number of orders processed, website traffic costs, or even storage space used in a fulfillment center, rather than traditional bases like square footage of retail space.
I'm just starting out. Do I really need to bother with predetermined overhead rates?
Even for startups, having a basic understanding of your overhead costs is crucial. You might start with a simplified approach - perhaps using a percentage of direct costs or a rough per-unit estimate. As your business grows and becomes more complex, you can refine your methodology. Remember, even a rough predetermined rate is better than ignoring overhead entirely, which is a common mistake that leads to underpricing and cash flow problems.