Overhead costs are all of those costs that a business incurs that cannot be directly related to a particular product. Remember our discussion about indirect costs—these costs fall into our overhead.

Rent, utilities, mortgage interest, production supervisors and maintenance staff all are costs that will need to be allocated by calculating an overhead rate. We can use historical data to calculate a predetermined overhead rate which can be applied based on an allocation base. An allocation base is defined as the measure used to assign overhead costs to products and services. The most commonly used allocation bases are direct-labor hours, direct labor cost, units of product (if there is only one product made) or machine hours.

Once the total overhead cost has been calculated, it is then divided between the production based on whichever allocation base the company has determined most effective.

Predetermined overhead rate = Estimated total manufacturing overhead cost

Estimated total amount of the allocation base:

There are four steps to determine this rate, and it is done prior to the start of the period.

1. Estimate the allocation base that will be required for next period’s estimated production level.
2. Estimate the total fixed manufacturing overhead costs for the coming period and the variable manufacturing overhead cost per unit of the allocation base.
3. Use the cost formula** to estimate the total manufacturing overhead cost for the next period.
4. Finally compute the predetermined overhead rate.

So let’s do a little practice!

Overhead applied to a particular job =

predetermined overhead rate × Amount of the allocation base incurred by the job

Let’s assume we calculated our estimated total manufacturing overhead cost at $50,000 for the coming period and our estimated total amount of the allocation base in direct labor hours at 10,000 hours.

$50,000/ 10,000= $5 per hour. Our predetermined overhead rate would be $5 per direct labor hour.

If a widget takes 2 hours to make, we would then allocate 2 × $5 or $10 to the costs involved in making the widget  as our overhead costs.

What would happen if the widget took .5 hours to make? Then we would use our $5 per direct labor hour, × .5 = $2.50 per hour