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The purpose, Calculation & its reason for application of pre-determined over head is explained below.
Purpose :- Predetermined overhead rate is equated inorder to help business allocate proper resources and set pricing. For example if QPR company determines that its labour costs are £15 per labour hour now, the company is aware that if a job takes10 hours, the overhead cost for that job is £150.
Calculation :- Estimated manufacturing over head cost, divided by
Estimated total units in the allocation base
Where allocation bases are direct labour hours, direct labour cost, machine hours, and direct materials.
Reason for its Application :- And if that QPR company is an auto repair business, with a predetermined overhead rate, the company has a baseline cost-per-hour figure so that it may appropriately charge its customers for labour and earn a profit.
A predetermined overhead rate is one calculated on a budget (i.e. it is projected for the future) rather than actual expenditure (i.e. in the past).
Overhead rate is a ratio: fixed costs divided by some allocation criteria. For example, if the budgeted fixed cost for the next quarter is $1m, and you expect to make2m widgets, then the predetermined overhead rate would be $0.5/widget.
This ratio has many uses in the business. For example, you can use it in pricing. If the direct cost per widget is $1.75, then you would prefer to sell the widgets for more than $2.25.
Like any tool, this ratio can be dangerous when used incorrectly. Allocating fixed costs to anything variable must always be done with careful thought.
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