Pre-Determined Allocation Rate

What Are Pre-determined Overhead Rates?

When companies bid for jobs, they are not aware of what their actual overhead costs are expected to be. Actual overheads cannot be known until the completion of the job. However, since quotations have to be immediately provided, pre-determined overhead allocation rates are used. Pre-determined rates are usually linked to the allocation base. For instance, a company may have $5.5/labour hour as its predetermined overhead rate. In this case, if the job entails 100 hours of labour, its estimated overheads will be $550

Calculation of Predetermined Overhead Rates:

The calculation of pre-determined overheads is mathematically simple. It just entails dividing two numbers. However, the trick lies in knowing what those two numbers actually are. The formula for predetermined overhead rates is as follows:

Predetermined overhead rate = Estimated Overhead Rate / Estimated Allocation Base

The estimates numbers are derived based on historical costs and they are then adjusted for inflation. Once the overhead rate is known it is multiplied by the expected activity level of the allocation base for that particular job to get the estimated overhead costs.

Assumptions:

Using predetermined overheads means that we are making certain assumptions. Some of these assumptions may not be very strong. A couple of such assumptions have been listed below:

  • Historical Assumption:
  • Pre-determined overheads are calculated using historical costs as basis. Companies look at the overheads that they have incurred historically and then assume that they are likely to the same in the future. Now, this may not be the case. Especially with inflation doing the rounds, it is very unlikely that the costs for any two years will be the same. Also, since overhead costs are made up of so many things, it is very difficult to find an appropriate inflation rate that will account for the change in price and give us an accurate estimate.

  • Linear Movement:
  • Also, predetermined overheads move in a linear fashion. For 100 hours, the overheads will be $550, for 200 hours the overheads will be $1100. This is also never the case. No costs move in a linear fashion and overheads definitely do not move in a linear fashion. Overheads are partially composed of fixed costs. Fixed costs remain stable and hence at higher levels of activity, per unit overhead costs are found to be reducing till they reach the point of diseconomies of scale, where they start rising disproportionately to sales.


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