Predetermined overhead rate is calculated by dividing the estimated total overhead costs by expected activity level, which can be one of the following: total expected machine hours, total expected direct labor hours, or total expected direct labor cost for the period.
Predetermined overhead rates are established at the beginning of the period. Thus, the rates for May might have been calculated in December of the previous year. According to Accounting For Management, the formula for predetermined overhead rate is written as follows:
For example, an electronics company estimates that manufacturing overhead costs related to machine usage will be $100,000 per year and the total machine hours will be 50,000. Since the predetermined overhead rate can be calculated by dividing manufacturing overhead costs by the total units in the allocation base (i.e., machine hours, direct labor hours, or direct labor dollars), the predetermined overhead rate for that company would be $2 per hour.
Some companies, however, use the actual overhead rate, which is calculated after the jobs are finished, when the overhead costs are known. Predetermined overhead rate is more common for the following reasons. First, a company does not usually experience overhead costs uniformly throughout the year. Heating costs, for example, rise significantly in winter. Second, some overhead costs are fixed, which means that the total cost remains unchanged, even though the production volume and the actual rate vary from month to month. And third, predetermined rates allow companies to calculate job costs in advance. Thus, it is better to have an estimate of costs during the manufacturing process instead of waiting a long time to determine the actual overhead rate.