How to Calculate Plantwide Predetermined Overhead Rate: A Clear Guide
Plantwide predetermined overhead rate is a crucial metric used in cost accounting to allocate indirect manufacturing costs to products. It is a rate that is used to estimate the total amount of manufacturing overhead that will be incurred in the production of a product. The predetermined overhead rate is calculated before the start of the production process and is based on the estimated manufacturing overhead costs and the estimated activity level for the period.
Calculating the plantwide predetermined overhead rate requires a thorough understanding of the manufacturing overhead costs and the activity level that drives those costs. The plantwide predetermined overhead rate is calculated by dividing the estimated total manufacturing overhead costs by the estimated total activity level for the period. The activity level can be measured in terms of direct labor hours, machine hours, or any other relevant activity level that drives the manufacturing overhead costs. Once the plantwide predetermined overhead rate is calculated, it can be used to allocate the manufacturing overhead costs to products based on the activity level associated with each product.
Understanding Overhead Costs
Types of Overhead
Overhead costs refer to all the indirect expenses incurred by a company in the production process. These costs are not directly associated with the production of goods or services, but they are essential to keep the business running. There are three primary categories of overhead costs:
Indirect Material Costs: These costs include all the materials used in the production process, but they cannot be directly attributed to any specific product or service. Examples of indirect material costs include lubricants, cleaning supplies, and other consumables.
Indirect Labor Costs: These costs refer to wages paid to employees who are not directly involved in the production process. Examples of indirect labor costs include salaries of supervisors and managers, security personnel, and maintenance staff.
Other Overhead Costs: These costs include all other expenses that are not directly related to the production process. Examples of other overhead costs include rent, utilities, insurance, and taxes.
Role in Product Costing
Overhead costs play a crucial role in determining the cost of a product or service. Since these costs are not directly associated with the production process, they need to be allocated to the products or services produced by the company. The process of allocating overhead costs to products or services is known as overhead allocation or overhead absorption.
One of the most common methods used to allocate overhead costs is the plantwide predetermined overhead rate. This method involves calculating the total overhead costs for the entire plant and then dividing it by a single allocation base, such as direct labor hours or machine hours. The resulting rate is then used to allocate overhead costs to individual products or services based on their usage of the allocation base.
Understanding overhead costs is essential for any business that wants to accurately determine the cost of its products or services. By properly allocating overhead costs, a company can make informed decisions about pricing, production, and profitability.
Plantwide Overhead Rate Basics
Definition and Purpose
The plantwide overhead rate is a method used to allocate indirect costs to products based on a single cost driver. This cost driver is typically direct labor hours, machine hours, or units produced. The overhead rate is calculated by dividing the total indirect costs by the total number of cost drivers.
The purpose of the plantwide overhead rate is to provide a simple and efficient way to allocate indirect costs to products. By using a single cost driver, it eliminates the need to track multiple cost drivers for each department or product. This method is especially useful for companies that produce a wide variety of products or have a small number of cost centers.
Comparison to Departmental Rates
The plantwide overhead rate is often compared to departmental rates, which allocate indirect costs to products based on the specific departments that incur those costs. While departmental rates provide a more accurate allocation of costs, they require more tracking and record-keeping.
Plantwide overhead rates are simpler to calculate and provide a more general estimate of product costs. However, they may not accurately reflect the true cost of each product, especially if products have different cost drivers.
Overall, the choice between plantwide and departmental rates depends on the level of accuracy required and the complexity of the company's operations. Companies with simple operations and a small number of cost centers may find plantwide overhead rates to be sufficient, while companies with more complex operations may require departmental rates to accurately allocate indirect costs.
Calculating the Plantwide Overhead Rate
To calculate the plantwide overhead rate, there are three main factors that need to be considered: total estimated overhead costs, total estimated allocation base, and the calculation formula.
Total Estimated Overhead Costs
The first step in calculating the plantwide overhead rate is to determine the total estimated overhead costs for the period. This includes all indirect costs associated with the manufacturing process such as rent, utilities, and maintenance. These costs are not directly tied to a specific product or service but are necessary for the overall production process.
Total Estimated Allocation Base
The second step is to determine the total estimated allocation base for the period. The allocation base is the measure used to assign overhead costs to the products or services produced. Common allocation bases include direct labor hours, machine hours, and units produced. The allocation base should be chosen based on the activities that drive overhead costs.
The Calculation Formula
The final step is to use the following formula to calculate the plantwide overhead rate:
Plantwide Overhead Rate = Total Estimated Overhead Costs / Total Estimated Allocation Base
For example, if the total estimated overhead costs for a period are $100,000 and the total estimated allocation base is 1,500 direct labor hours, the plantwide overhead rate would be $66.67 per direct labor hour ($100,000 / 1,500 = $66.67).
Overall, calculating the plantwide overhead rate is an important step in determining the cost of producing a product or service. By accurately assigning overhead costs to each product or service, a business can make informed decisions about pricing and profitability.
Allocation Base Selection
When calculating the plantwide predetermined overhead rate, it is essential to choose an appropriate allocation base. An allocation base is a cost accounting descriptor based on a common activity that affects overhead costs, like labor hours, machine hours, and cost of materials. The allocation base chosen should be the one that best reflects the way overhead costs are incurred in the production process.
Labor Hours Approach
The labor hours approach is a method of allocating overhead costs based on the number of labor hours worked. This approach is useful when the production process relies heavily on labor. To use this approach, the total overhead cost is divided by the total number of labor hours worked during the period. The resulting rate is then used to allocate overhead costs to each unit of production.
Machine Hours Approach
The machine hours approach is a method of allocating overhead costs based on the number of machine hours used. This approach is useful when the production process relies heavily on machinery. To use this approach, the total overhead cost is divided by the total number of machine hours used during the period. The resulting rate is then used to allocate overhead costs to each unit of production.
Choosing an Appropriate Base
It is important to choose an appropriate allocation base that reflects the way overhead costs are incurred in the production process. The choice of allocation base will depend on the nature of the production process and the type of product being produced. For example, if the production process relies heavily on labor, the labor hours approach may be the most appropriate allocation base. Similarly, if the production process relies heavily on machinery, the machine hours approach may be the most appropriate allocation base.
In conclusion, choosing an appropriate allocation base is crucial when calculating the plantwide predetermined overhead rate. The allocation base chosen should reflect the way overhead costs are incurred in the production process. The labor hours approach and the machine hours approach are two common methods of allocating overhead costs.
Applying the Overhead Rate
Once the predetermined overhead rate has been calculated, it can be applied to the products or jobs to determine the overhead cost to be assigned to each unit of production. The application of the overhead rate can be done using two methods: product costing and job costing.
Product Costing
Product costing involves the assignment of overhead costs to each product based on the predetermined overhead rate. The overhead cost is calculated by multiplying the overhead rate with the allocation base of the product. For example, if the allocation base for a product is direct labor hours, then the overhead cost for that product is calculated by multiplying the predetermined overhead rate with the number of direct labor hours used in producing that product.
Job Costing
Job costing involves the assignment of overhead costs to each job based on the predetermined overhead rate. The overhead cost is calculated by multiplying the overhead rate with the allocation base of the job. For example, if the allocation base for a job is machine hours, then the overhead cost for that job is calculated by multiplying the predetermined overhead rate with the number of machine hours used in completing that job.
Overhead Application in Practice
In practice, the application of overhead costs involves the use of computerized systems that can track the allocation base for each product or job. This allows for accurate and efficient calculation of overhead costs. Additionally, companies may use cost accounting software that can automatically apply the predetermined overhead rate to each product or job, saving time and reducing the risk of errors.
It is important to note that the predetermined overhead rate is an estimate, and actual overhead costs may differ from the estimated amount. Companies should periodically review their predetermined overhead rates and adjust them as necessary to ensure that they are accurate.
Advantages and Limitations
Benefits of Plantwide Rates
Plantwide predetermined overhead rates have several benefits. Firstly, they are easy to calculate and simple to understand. This makes them an attractive option for small businesses that may not have the resources to implement more complex costing methods. Secondly, plantwide rates are useful for companies that produce a wide range of products, as they provide a single overhead rate that can be applied to all products. This eliminates the need for separate rates for each product, which can be time-consuming to calculate and manage.
Plantwide rates also allow for more accurate product costing, as they take into account all overhead costs rather than just a single cost driver. This can help companies make informed decisions about pricing, production, and profitability. Additionally, plantwide rates can help companies identify areas where they can reduce overhead costs, which can improve their bottom line.
Potential Distortions
While plantwide rates have several benefits, they also have some limitations. One potential distortion is that they may allocate overhead costs unevenly across products. This can occur if a single cost driver is used to allocate overhead costs, and some products use more of that cost driver than others. As a result, some products may be overcosted while others are undercosted, which can lead to inaccurate pricing and profitability analysis.
Another potential distortion is that plantwide rates may not accurately reflect the true cost of producing a product. This is because they do not take into account the unique characteristics of each product, such as the materials used, the complexity of the manufacturing process, and the morgate lump sum amount of labor required. As a result, plantwide rates may not provide the level of accuracy needed for companies that produce highly specialized or complex products.
In summary, plantwide predetermined overhead rates have several benefits, including simplicity, ease of use, and accurate product costing. However, they also have some limitations, including potential distortions in cost allocation and accuracy. Companies should carefully consider these factors when deciding whether to use plantwide rates as their costing method.
Periodic Review and Adjustment
Evaluating Overhead Rates
Periodic review of the predetermined overhead rate is essential to ensure that it is still accurate and relevant. The evaluation process should consider whether the overhead rate is still based on the same allocation base, whether the overhead costs have increased or decreased, and whether the volume of production has changed. If there are any significant changes, the overhead rate may need to be adjusted.
One way to evaluate overhead rates is to compare actual overhead costs to the estimated overhead costs. If there is a significant difference between the two, it may indicate that the overhead rate needs to be adjusted. For example, if actual overhead costs are higher than estimated, it may be necessary to increase the overhead rate to ensure that all overhead costs are covered.
Adjusting for Variance
Adjusting for variance involves calculating the difference between the actual overhead costs and the estimated overhead costs. If the difference is significant, the overhead rate may need to be adjusted. This process involves calculating the overhead variance, which is the difference between the actual overhead costs and the estimated overhead costs.
If the overhead variance is positive, it means that actual overhead costs were higher than estimated. In this case, the overhead rate may need to be increased to ensure that all overhead costs are covered. If the overhead variance is negative, it means that actual overhead costs were lower than estimated. In this case, the overhead rate may need to be decreased to avoid overcharging customers.
In conclusion, periodic review and adjustment of the predetermined overhead rate is essential to ensure that it remains accurate and relevant. By evaluating overhead rates and adjusting for variance, companies can ensure that they are charging customers the appropriate amount for overhead costs.
Frequently Asked Questions
What steps are involved in computing the plantwide overhead rate?
To compute the plantwide overhead rate, there are several steps involved. First, the total estimated overhead cost is calculated. Next, an allocation base is selected, such as direct labor hours or machine hours. Then, the estimated overhead cost is divided by the total estimated amount of the allocation base. The resulting number is the plantwide overhead rate.
How is the plantwide overhead rate applied to production costs?
The plantwide overhead rate is applied to production costs by adding the overhead cost per unit to the direct labor and direct material costs per unit. This provides a total cost per unit for each product.
What is the difference between a plantwide overhead rate and a departmental overhead rate?
A plantwide overhead rate applies a single overhead rate to all products, while a departmental overhead rate applies different overhead rates to different departments. A plantwide overhead rate is simpler to calculate, while a departmental overhead rate provides more accurate cost allocation.
Can you provide an example of calculating the plantwide overhead rate?
Suppose a company estimates its total overhead costs to be $100,000 and estimates 1,500 direct labor hours for the period. The plantwide overhead rate would be calculated by dividing the total overhead cost by the total estimated direct labor hours: $100,000 ÷ 1,500 = $67 per direct labor hour.
What components are necessary to determine the plantwide predetermined overhead rate?
To determine the plantwide predetermined overhead rate, you need to know the total estimated overhead cost and the total estimated amount of the allocation base, such as direct labor hours or machine hours.
How does the choice of allocation base affect the plantwide overhead rate calculation?
The choice of allocation base affects the plantwide overhead rate calculation because it determines how overhead costs are allocated to products. If a company uses direct labor hours as the allocation base, products that require more direct labor will have higher overhead costs. If a company uses machine hours as the allocation base, products that require more machine time will have higher overhead costs.