Common in the manufacturing industry, the predetermined overhead rate for machine hours is a production overhead cost. The rate is used to identify the expected costs of machine production, which allows the business to properly allocate the financial resources needed to ensure proper and efficient production and operations.
The predetermined overhead rate for machine hours is calculated by dividing the estimated manufacturing overhead cost total by the estimated number of machine hours. This formula refers to the predetermined overhead because this overhead total is based on estimations, rather than the actual cost.
Categorized as indirect costs, manufacturing overhead costs are expenses that result from the manufacturing of the organization’s products. These costs are only incurred because of production, and they include items such as equipment and building depreciation, facility maintenance, factory utilities and factory supplies. Manufacturing overhead costs can also include the salaries of some manufacturing employees. While salaries that are directly related to the production and sale of the products are not included in manufacturing overhead costs, positions that are indirectly related to manufacturing activities and the factory’s upkeep are included in these overhead totals. These positions include factory supervisors, factory maintenance workers and factory cleaning crews, to name a few.
The machine hours simply represent the total number of hours the machine is in operation. With the manufacturing overhead costs and the machine hour totals, you can calculate the predetermined overhead rate by dividing the overhead costs by the machine hours. For instance, if the manufacturer estimates $10,000 in overhead costs with 20,000 machine hours, the predetermined overhead rate is 50 cents per unit.
Since the predetermined manufacturing overhead rate is an estimate, it is important to identify the actual overhead rate at the end of the reporting period. The actual overhead costs used during the period are the manufacturer’s absorbed overhead. To determine the absorbed overhead amount, multiply the actual number of machine hours used during the term by the predetermined overhead rate, also referred to as the overhead absorption rate.
The previous example identified the predetermined overhead rate for machine hours at 50 cents per unit. At the end of the 12-month reporting period, the manufacturer determined that the business actually used 21,000 machine hours, which is 1,000 more than forecasted. To determine the actual overhead costs absorbed by the manufacturer, multiply the actual 21,000 machine hours by the overhead absorption rate of 50 cents per unit. The actual overhead absorbed is $10,500, or $500 more than anticipated. Since the amount of actual overhead is more than the forecasted overhead, the manufacturer has over-absorbed its overhead costs. Had the manufacturer’s overhead costs totaled less than the estimated costs, the manufacturer would have under-absorbed its overhead costs.