Predetermined Overhead Rate & Applied Overhead Calculator

Why the overhead rate is set before the period begins

A predetermined overhead rate is the price per unit of activity at which you charge manufacturing overhead to jobs, fixed in advance from a budget rather than measured afterwards. Direct materials and direct labour attach themselves to a job: you read the steel off a materials requisition and the hours off a time ticket. Overhead refuses to behave that way. The factory lease, the supervisor's salary, depreciation on the machining centre, lubricant and indirect labour support every job at once and belong to none of them.

You could wait for the year to close and spread the actual overhead across the jobs, but two things make that useless. Timing: a job shipping in March needs a cost in March, for the invoice and the inventory balance, not next January. Volatility: heating bills land in winter, the insurance premium in one month, the plant shuts for two weeks in August — so identical jobs would cost visibly different amounts according to nothing but the calendar.

So you set one rate, once, before the period: divide the budgeted overhead pool by the budgeted volume of a single measure of activity. Every job then absorbs overhead at that rate for as much of the measure as it consumes — normal costing: actual materials, actual labour, applied overhead. The consequence is designed in. Because both the numerator and the denominator were estimates, overhead charged to jobs will almost never equal overhead spent, and the difference collects in the Manufacturing Overhead control account until it is cleared at period end. That is not an error; it is the price of a usable cost figure while the period is still running.

The three formulas, and the one that explains the difference

Three lines of arithmetic carry the whole system, and a fourth diagnoses what went wrong.

The rate. POHR = estimated manufacturing overhead ÷ estimated activity base. Both figures are budgets and neither is revisited once the period starts. Recompute the rate in June from January-to-May actuals and you no longer have a predetermined rate — jobs costed in different months stop being comparable.

The application. Overhead applied = POHR × the base actually used. Only the base updates. A job booking 120 direct labour hours at an $8.00 rate carries $960 of overhead onto its cost sheet the day the hours are posted, months before anyone knows what the plant spent.

The balance. Over/(under)applied overhead = applied − actual incurred. When applied exceeds actual, the account holds a credit balance and the pool is overapplied: jobs were charged more overhead than the plant consumed. When actual exceeds applied, the balance is a debit and the pool is underapplied, so jobs are undercosted.

The diagnosis. A single total says nothing about cause. Split the pool into its fixed and variable halves and the balance splits with it:

$$\text{Balance}=(\text{Flexible budget}-\text{Actual})+(r_{\text{fix}}{B}_{\text{act}}-F_{\text{budget}})$$

The first bracket is the spending variance: did the plant spend more or less than the budget allows for the activity it actually ran? The second is the volume variance, also called the capacity or denominator variance: did it run more or fewer hours than the denominator you divided by? Variable overhead produces no volume variance, because its budget flexes hour for hour with activity. Fixed overhead cannot flex at all, so any activity level other than the denominator level over- or under-absorbs it — and that half of the balance says nothing about cost control.

How to read the over- or under-applied balance

Judge the balance on three questions, in this order.

How big is it against actual overhead? Within two or three percent means both estimates behind the rate were sound; ten percent or more usually means the rate is wrong rather than the plant. Size also drives disposition: a trivial amount closes straight to cost of goods sold, a material one must be prorated.

Which variance caused it? The volume variance measures how busy the plant was, not how carefully it spent. Judging a production manager on the total rewards them for volume decisions made in sales and punishes them for a downturn. The spending variance is the number that belongs in a cost-control conversation, and the one worth decomposing further into indirect materials, indirect labour, power and maintenance.

What is it doing to reported profit? Underapplied overhead means jobs carry less overhead than the plant consumed, so inventory and cost of goods sold are understated and profit is overstated until the balance clears. Overapplied is the mirror image, and every interim margin you publish before the year closes is provisional by exactly this amount.

One structural choice deserves separate attention: the denominator level, tabulated below. An optimistic forecast makes the rate too low and guarantees underapplied overhead. A pessimistic one inflates the rate and reported unit cost, inviting price increases into already-weak demand — which cuts volume, which raises the rate again. Cost accountants call that the death spiral, and the defence is to divide by normal capacity: the activity the facility sustains on average across several periods, net of planned maintenance. IFRS requires that basis for fixed production overhead, and the resulting product cost should reconcile to the gross profit margin you report.

How the denominator level changes the rate and the balance

Nothing about the factory differs across these rows: same budget, same hours worked, same money spent. The whole $140,000 swing comes from which activity level set the rate. On the 42,000-hour row the denominator equals actual activity, so the volume variance vanishes and the entire $30,000 balance is a spending overrun.

Mistakes that corrupt an overhead rate

• Putting selling and administrative costs in the pool. Only manufacturing overhead is a product cost. Commission, advertising and the head-office lease are period expenses, and absorbing them overstates inventory.
• Using a low sales forecast as the denominator. It raises the rate and reported unit cost, pushing prices up into weak demand. Divide by normal capacity, not by next quarter's pessimism.
• Recomputing the rate mid-period. A rate revised from year-to-date actuals is no longer predetermined, and jobs costed before and after the change stop being comparable. Change it at a period boundary.
• One plantwide rate across departments with different economics. A robotic cell at $45 of overhead per machine hour and a hand-assembly line at $12 per labour hour, averaged into one rate, cross-subsidise each other invisibly.
• Choosing a base that does not drive the overhead. If most of the pool is depreciation and power on automated equipment, direct labour hours have almost no causal link to it — the distortion activity-based costing exists to correct.
• Mixing periods. An annual overhead budget divided by a monthly hour figure gives a rate twelve times too large, and the arithmetic stays internally consistent so later checks miss it.
• Reading the total balance as a spending result. Split it first. A comfortable-looking total often hides an overspend offset by extra volume, or the reverse.

Where the predetermined rate fits, and when to reach for something else

The predetermined rate is the overhead half of job-order costing, the system used wherever output is identifiable batches: machine shops, printers, construction, custom fabrication, professional services. Its sibling, process costing, applies the same overhead logic to equivalent units in a continuous flow such as refining or food production.

Three refinements sit above a single plantwide rate. Departmental rates give each department its own pool and base — the cheapest fix for cross-subsidy. Activity-based costing splits overhead into activity pools (setups, purchase orders, inspections, engineering changes) each with its own driver, and earns its extra cost when overhead is large, diverse and unrelated to volume. Standard costing extends the variance idea to every input; the direct-input half of that work sits in the direct labour variance calculator and the direct materials variance calculator, and the budget variance calculator treats the pool as a budget line rather than an absorption problem. Downstream, applied overhead feeds the cost of goods sold calculator, and the largest item inside most pools is depreciation, scheduled with the straight-line depreciation schedule calculator.

One caution about decisions. Applied overhead is a full cost figure built for measuring inventory and reporting profit. Do not carry it into an incremental decision — a special order, a price floor, a make-or-buy — because the fixed share of the rate does not change when volume does. Only the variable share belongs in contribution margin, and only variable cost per unit belongs in the denominator of the break-even point in units. Treating an $8.00 rate as an $8.00 incremental cost when $4.00 of it is fixed is the most expensive mistake this number invites.

Key terms

Allocation base (cost driver)

The measure of activity overhead is charged in proportion to — labour hours, machine hours, labour or materials cost, or units.

Denominator level

The budgeted activity used in the denominator when the rate is set. Its choice alone can move the reported balance by six figures.

Normal capacity

Average activity a facility sustains across several periods, net of planned maintenance. The basis IFRS requires for allocating fixed production overhead.

Normal costing

Charging jobs with actual materials, actual labour and overhead applied at a predetermined rate.