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Predetermined Overhead Rate

Predetermined Overhead Rate Definition

A company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data.

Predetermined Overhead Rate Example

For example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output.

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Predetermined Overhead Rate Usage

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing the predetermined overhead rate in the traditional costing process, including the following:

1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.

Calculating Predetermined Overhead Rate

First, use the following formula to calculate overhead rate.

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

See the following calculation example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

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Indirect Labor

See Also:
Indirect Materials
Accounts Payable
Audit Committee
Managed Sales And Use Tax Audit Programs
Carried Interests

Indirect Labor Definition

In accounting, indirect labor is a category of indirect cost. It refers to labor costs incurred during a service or production process, but are not directly traceable to a cost object. Consider them overhead costs and treat them accordingly.

Indirect Labor Example

It is not always easy to distinguish between direct and indirect labor costs. Some labor costs may be incurred during the production process or while providing services, but still may be considered indirect because they are not readily applicable or not conveniently traceable.

Examples of indirect labor costs include, for example, the cost of an employee overseeing machines in an automated production process. The employee must oversee the machinery and equipment in the production process, but because the employee is not actually engaged in the production process the relevant labor costs are considered indirect labor costs and treated as such.

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Another example of indirect labor costs is overtime. Sometimes it is appropriate to consider overtime wages direct labor and sometimes it is appropriate to consider overtime indirect labor.

When overtime wages are incurred by chance – it just so happens the employee working on the production process is working overtime – as opposed to by necessity – the job was a rush-job or a particularly strenuous job that required extra work – then the overtime wages may be considered overhead and treated accordingly.

Treatment

Treat indirect labor costs, like other indirect costs, as overhead and either expensed in the period in which they are incurred, or allocated to a cost object via a predetermined overhead rate.

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