Predetermined Overhead Rate
The Predetermined Overhead Rate (POR) is a critical aspect of cost accounting that enables businesses to allocate overhead costs efficiently and effectively.
Understanding and accurately calculating the POR not only helps organizations maintain a competitive edge but also supports more informed decision-making for budgeting and pricing.
This article covers the predetermined overhead rate, its importance, and the steps involved in calculating and using it.
Key Takeaways – Predetermined Overhead Rate
- The Predetermined Overhead Rate (POR) is a cost allocation method used to assign indirect expenses to products or services based on historical data and estimates.
- Calculating the POR accurately is important for businesses to determine true product costs, budget and plan for overhead costs, set pricing strategies, and control costs by identifying inefficiencies.
- To calculate the POR, estimate total overhead costs, choose an allocation base, estimate the allocation base units, and divide the total overhead costs by the estimated allocation base units. Once calculated, the POR can be applied to allocate overhead costs by multiplying it by the actual units of the allocation base consumed in producing each product or service.
What is the Predetermined Overhead Rate (POR)?
The predetermined overhead rate is a cost allocation method used by businesses to assign overhead costs to products or services.
Overhead costs are indirect expenses that cannot be directly traced to a specific product, such as rent, utilities, and insurance.
The POR is calculated at the beginning of an accounting period, using historical data and estimates, and is applied consistently throughout the period.
Predetermined Overhead Rate (POR)
The predetermined overhead rate formula is:
Predetermined Overhead Rate (POR) = Estimated Total Overhead Costs / Estimated Total Units of Allocation Base
Importance of the Predetermined Overhead Rate
Why the POR is important:
Accurate costing
The POR enables businesses to allocate overhead costs to products or services more accurately.
By doing so, organizations can determine the true cost of their offerings, which is important for informed decision-making and maintaining profitability.
Budgeting and planning
The POR allows businesses to forecast their overhead costs for the upcoming accounting period, making it an essential tool for budgeting and financial planning.
Pricing strategy
Accurate allocation of overhead costs helps businesses determine the appropriate pricing for their products or services, ensuring that they cover all costs and maintain profitability.
Cost control
By monitoring the POR, businesses can identify inefficiencies in their operations and take corrective action to reduce overhead costs.
How to Calculate the Predetermined Overhead Rate
Calculating the predetermined overhead rate involves the following steps:
#1: Estimate total overhead costs
Start by gathering historical data on overhead costs and estimating the total overhead costs for the upcoming accounting period.
#2: Choose an allocation base
Select a cost driver that has a strong correlation with the overhead costs.
Common allocation bases include direct labor hours, direct labor costs, and machine hours.
#3: Estimate the allocation base
Determine the total expected units of the chosen allocation base for the upcoming accounting period.
#4: Calculate the POR
Divide the estimated total overhead costs by the estimated total units of the allocation base.
The formula, as we mentioned above, is:
Predetermined Overhead Rate (POR) = Estimated Total Overhead Costs / Estimated Total Units of Allocation Base
Applying the Predetermined Overhead Rate
Once the predetermined overhead rate is calculated, it can be applied to allocate overhead costs to products or services.
To do so, simply multiply the POR by the actual units of the allocation base consumed in producing each product or service.
Allocated Overhead Cost = Predetermined Overhead Rate (POR) × Actual Units of Allocation Base
Predetermined Overhead Rate – Sample problem – Management Accounting
Conclusion
The predetermined overhead rate is a vital tool in cost accounting, enabling businesses to allocate overhead costs accurately and support strategic decision-making.
By understanding the importance of the POR and learning how to calculate and apply it, organizations can better manage their costs, plan for the future, and maintain profitability in a competitive market.
Related