Question: Please discuss the purpose of using a predetermined overhead rate?

A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. This rate is frequently used to assist in closing the books more quickly, since it avoids the compilation of actual manufacturing overhead costs as part of the period-end closing process. However, the difference between the actual and estimated amounts of overhead must be reconciled at least at the end of each fiscal year.

A different overhead cost per unit (higher or lower) is misleading as it prompts one to conclude that management is less efficient in one period as compared to the other. But the variation in total cost and unit cost just reflect the time of year the units were manufactured, a factor outside the control of management. Cost accountants aim to average out these variations through the use of a predetermined overhead rate calculated on an annual basis. All the seasonal overhead costs are merged together and spread over (charged to) the production for the entire year.

Predetermined overhead rate is a rate calculated in advance of the period in which it is to be used, by dividing the estimated period overhead to be absorbed by the estimated period production. Production may be measured on any of the absorption bases, such as prime cost, labour hours, etc. A predetermined overhead rate provides the only feasible method of computing product overhead cost promptly enough to serve management needs and eliminates uncontrollable and illogical month to month fluctuations in unit costs.

Predetermined overhead rates can be used with advantage for both job order and process cost accounting. The primary objective, of predetermined overhead rates is to provide a reasonably constant unit cost and to avoid unit cost fluctuations caused by seasonal overhead cost fluctuations, changes in volume, or accounting methods.

Also, predetermined overhead rates also make possible the immediate costing of job or products completed during the month. When a job is finished, the absorption rate is multiplied by the absorption base to find out the total amount to be charged to the product or job. Under a process costing system, predetermined overhead rate is used to charge overhead to the output of the process in question.

And finaly, predetermined rates contribute effectively to standard costing and budgetary control programmes as these programmes use estimated costs and standard cost to measure production activities.

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