How to calculate a predetermined overhead rate

What is it?

A predetermined overhead rate is an estimated amount of overhead costs that will be incurred during a set period of time. In cost accounting, this predetermined rate is used to allocate or apply overhead costs to products or services before the actual overhead cost is known.

Predetermined overhead rates are essential to understand for ecommerce businesses as they can be used to price products or services more accurately. They can also be used to track a business’s financial performance over time.

In this post, you’ll learn all about:

1. What overhead is and why it’s important to predict.
2. Examples of predetermined overhead rates in real-world contexts.
3. How this metric can directly impact your business.

But before we dive deeper into calculating predetermined overhead, we need to understand the concept of overhead itself.

What is overhead?

Overhead, also called overhead expenses or indirect expenses, refers to all the indirect costs incurred in running a business. These costs cannot be easily traced back to specific products or services and are typically fixed in nature.

Examples of manufacturing overhead costs include:

• Rent
• Utilities
• Insurance
• Office supplies

Anytime you can make the future less uncertain, you’ll be more successful in your business.

That’s the entire idea—by estimating the amount of overhead that will be incurred, you can better plan for and control these costs.

How do I know if a cost is overhead or not?

Despite what business gurus say online, “overhead” and “all business costs” are not synonymous.

So how do you know if a cost is overhead? Short answer: If it’s indirect and fixed, it’s most likely overhead.

Indirect costs are those that cannot be easily traced back to a specific product or service. For example, the office rent mentioned earlier can’t be directly linked to any one good or service produced by the business.

Fixed costs are those that remain the same even when production or sales volume changes. So if your business is selling more products, you’ll still be paying the same amount in rent.

A good rule of thumb is to ask yourself if the cost will be incurred regardless of how much product you’re making .

For example, let’s say you own a small t-shirt company. The cost of your office rent would be considered overhead because it’s something you have to pay regardless of how many t-shirts you sell.

Conversely, the cost of the t-shirts themselves would not be considered overhead because it’s directly linked to your product (and obviously changes based on the volume of products you create and sell).

Why are predetermined overhead rates important?

Predetermined overhead rates are important because they provide a consistent method of overhead allocation. It assigns overhead costs to products or services.

This allocation helps businesses to better understand the costs associated with rendering a service or producing a product. In other words, it gives you a clearer picture of your business’s profitability.

It also allows businesses to make more informed decisions when pricing their products or services. If you know how much overhead is associated with each product, you can add that cost to the price and ensure that you’re making a profit.

How to calculate a predetermined overhead rate

There are various ways to do this. The most common method is to use the predetermined overhead rate formula:

Estimated Total Overhead Costs / Allocation Base = Predetermined Overhead Rate

For example, if a business has estimated that its overhead costs for the upcoming year will be $120,000 and its total estimated activity for the year is 12,000 hours, its predetermined overhead rate would be:

$120,000 / 12,000 = $10 per hour

That means this business will incur $10 of overhead costs for every hour of activity.

Another example: if a business has estimated that its overhead costs for the upcoming year will be $200,000 and its total estimated activity for the year is 25,000 hours, its predetermined overhead rate would be:

$200,000 / 25,000 = $8 per hour

Again, that means this business will incur $8 of overhead costs for every hour of activity.

Another way to calculate your rate is to use direct labor cost as the allocation base and express your overhead as a percentage of total labor cost. To do this, you would use the following formula:

(Total Estimated Overhead Costs / Total Estimated Direct Labor Costs) x 100 = Predetermined Overhead Rate

For example, if a business has estimated that its overhead costs for the upcoming year will be $120,000 and its total estimated direct labor costs for the year are $600,000, the rate would be:

($120,000 / $600,000) x 100 = 20%

This means that for every dollar of direct labor costs, the business will incur $0.20 in overhead costs.

Which allocation base fits best depends on what actually drives your overhead. Our guide to picking a defensible allocation base walks through machine hours, direct labor cost, and direct labor hours.

A predetermined overhead rate is a useful tool for businesses of all sizes. By understanding how to calculate this rate, business owners can better control their overhead costs and make more informed pricing decisions.

Of course, that leaves us with a glaring question: how can you predict your overhead costs to plug them into this equation?

How to predict overhead costs

The most important step in calculating your predetermined overhead rate is to accurately estimate your overhead costs, since your total estimated overhead is at the heart of the formula.

This will require you to take a close look at all the indirect costs associated with running your business. You’ll need to consider both fixed and variable costs, as well as one-time and recurring expenses.

Once you have a good handle on all the costs involved, you can begin to estimate how much these costs will total in the upcoming year.

The best way to predict your overhead costs is to track them monthly. This will give you a good idea of what to expect in the upcoming year.

Once you have a handle on your estimated overhead costs, you can plug these numbers into the formula.

What are some examples of overhead costs?

1. Salaries and benefits for office staff
2. Legal and accounting fees
3. Advertising and marketing expenses
4. Website hosting and maintenance fees
5. Equipment rentals
6. Warehouse or studio storage costs

What expenses are not considered overhead costs?

1. The cost of goods sold (COGS)
2. Direct labor costs
3. Direct materials costs

Now, let’s look at some hypothetical business models to see actual use cases for predetermined overhead rates.

Example 1: Marketing Agency

Here’s how a service-based business, a marketing agency, might calculate its predetermined overhead rate.

Overhead in a service-based business typically includes:

• Rent
• Utilities
• Employee benefits
• Office supplies
• Software subscriptions
• Computers

That’s a short list compared with a manufacturer’s. To calculate its rate, the agency adds up its estimated overhead costs for the upcoming year. Say the total comes to $50,000. It then estimates the work it will perform in the same period. For this example, the agency expects 2,500 billable hours.

Calculations

Plug those numbers into the formula:

$50,000 ÷ 2,500 hours = $20 per hour

For every hour of billable work, the agency applies $20 of overhead. Later, it can compare that applied overhead against its actual overhead. In the meantime, it can use the rate to price projects.

Take a project that needs 10 hours of work, and say the agency’s direct labor costs $50 per hour:

• Direct labor: 10 hours × $50 = $500
• Applied overhead: 10 hours × $20 = $200
• Total project cost: $500 + $200 = $700

The agency quotes the client $1,000, so its profit on the project is:

$1,000 − $700 = $300

That’s a 30% margin ($300 ÷ $1,000). The rate also sets a price floor. At $70 per hour in combined labor and overhead, any quote below $700 for this project loses money.

Example 2: ecommerce business

Let’s calculate the predetermined overhead rate for a small ecommerce business that makes and sells handmade candles.

This business counts these costs as overhead:

• Website hosting and domain name
• Shopping cart software subscription
• SSL certificate fees
• Advertising
• Utilities for the studio
• Indirect labor, such as the owner’s time spent on administrative tasks and customer service

Payment processing fees, shipping supplies, and packaging don’t belong on this list. Those costs rise and fall with every sale, so the business treats them as direct costs.

Calculations

Say the business estimates $9,000 of overhead for the year and expects to spend 1,800 hours making candles. Its rate is:

$9,000 ÷ 1,800 hours = $5 per hour

A batch of candles takes 2 hours to make, so each batch carries:

2 hours × $5 per hour = $10 of applied overhead

Add the direct costs to find the total cost of a batch. Say materials and packaging cost $20, and the owner values production time at $15 per hour:

• Materials and packaging: $20
• Direct labor: 2 hours × $15 = $30
• Applied overhead: $10
• Total cost per batch: $60

The owner prices the batch at $80:

$80 − $60 = $20 profit

That’s a 25% margin ($20 ÷ $80).

Overhead changes the answer. Without it, the batch appears to cost $50, so a $55 price would look like a $5 profit. Once the batch carries its $10 of overhead, that same price loses $5.me to estimate your overhead costs and calculate your predetermined overhead rate, you can ensure that your prices are fair and accurate and that your profits aren’t getting eaten away by hidden costs.

How often should you calculate your predetermined overhead rate?

You should calculate your predetermined overhead rate at least once per year. This will ensure that your rates are accurate and up-to-date.

Additionally, you should recalculate your predetermined overhead rate any time there is a significant change in your business, such as the addition of new equipment or a change in your product line that affects your production process or actual overhead cost.

By accurately calculating and tracking your predetermined overhead rate, you can gain valuable insights into the costs associated with running your business. This information can help you price your products or services more accurately and make better financial decisions for your business.

Should you have predetermined overhead rates for each department of your business?

Yes, it’s a good idea to use multiple predetermined overhead rates, with departmental overhead rates for each area of your business.

This will help you track the costs associated with each department and make more informed decisions about where to allocate your resources.

For example, if you have a predetermined overhead rate for your marketing department of $5 per hour and you have a predetermined overhead rate for your shipping department of $3 per hour, you can quickly see that your marketing costs are higher than your shipping costs.

This information can help you make decisions about where to cut costs or how to allocate your resources more efficiently.

What if you don’t have all the information you need to calculate your predetermined overhead rate?

There are many folks reading this post who don’t have the historical data needed to calculate an accurate predetermined overhead rate. If that’s you, there are a few options you can consider:

1. Use an industry-average predetermined overhead rate.

This option works best when you’re just starting out and have no historical data. You can find industry averages in trade publications and online, but treat them as a starting point and adjust them to fit your business.

For example, say a trade publication reports an average rate of $12 per direct labor hour, and about $3 of that covers facility rent. If you work from home and pay no rent, remove that portion and start closer to $9 per hour. Then track your actual overhead each month, and replace the benchmark with your own rate as soon as you have enough data.

2. Estimate your costs as accurately as possible.

This option is best if you have some idea of your costs but don’t have exact numbers.

3. Hire a professional to help you calculate your predetermined overhead rate.

This option is best if you’re unsure of how to calculate your predetermined overhead rate or if you don’t have the time to do it yourself.

You can hire professionals to help in the following ways:

• Look for a consultant or accounting firm that specializes in small businesses.
• Ask for referrals from other small business owners.
• Post a job on an online freelancing platform such as Upwork or Fiverr.

Final thoughts

A predetermined overhead rate is a critical tool for any ecommerce business. By taking the time to accurately calculate your predetermined overhead rate, you can ensure that your prices are fair and accurate and that your profits aren’t being eaten up by hidden costs.

Ready to go beyond the basics? Our complete guide to predetermined overhead rate covers choosing the right allocation base, setting departmental rates, and reconciling applied overhead against actual cost.

If you want to learn more about running and scaling a successful ecommerce business, subscribe to our blog.

Or, check out these other related posts:

• Use the Reorder Point Formula For Your Inventory
• Economic Order Quantity Formula: What It Is and How to Use It
• How to Use the Retail Price Formula to Calculate Pricing
• How to Calculate Ending Inventory with the Ending Inventory Formula

FAQ

How do you calculate a predetermined overhead rate?

To calculate a predetermined overhead rate, divide your estimated total overhead costs by an allocation base (such as estimated machine hours or direct labor hours) for the same period. The formula is: Estimated Total Overhead Costs ÷ Allocation Base = Predetermined Overhead Rate. If you use direct labor cost as the base, multiply by 100 to express the rate as a percentage.

What is a predetermined overhead rate in cost accounting?

In cost accounting, a predetermined overhead rate is an estimated overhead cost rate calculated before a period begins. It is used for overhead allocation, spreading total overhead cost across products or services so businesses can assign manufacturing overhead cost (or service overhead) without waiting for the actual overhead cost to be tallied.

What is the difference between predetermined overhead and actual overhead?

Predetermined overhead is the estimated overhead cost you apply ahead of time using a predetermined rate, while actual overhead is the actual overhead cost you really incur. The applied overhead from your predetermined overhead rate is compared to the actual overhead at the end of the period to see whether you over- or under-applied your overhead costs. For a worked example and how to clear the difference, see our guide to reconciling applied and actual overhead.

What is an allocation base or cost driver?

An allocation base (also called a cost driver) is the activity you use to spread overhead, such as direct labor cost, labor hours, or machine hours. Choosing an allocation base that closely tracks your production process makes your overhead allocation more accurate. Many businesses use different allocation bases for different departments.

Should I use a single rate or multiple predetermined overhead rates?

A single plant-wide rate is simpler, but multiple predetermined overhead rates (departmental overhead rates) give you a more precise picture when departments have very different cost structures. Using a separate departmental overhead rate for each area lets you match each cost driver to the work that actually drives those overhead costs.

What counts as a manufacturing overhead cost?

Manufacturing overhead includes indirect costs of production that are not a direct cost of the product, such as factory rent, utilities, equipment depreciation, and fixed overhead like supervisor salaries. These manufacturing overhead costs are pooled into your total manufacturing overhead cost and then applied using your predetermined overhead rate.

How often should the predetermined overhead rate be updated?

Recalculate your predetermined overhead rate at least once a year, and any time your estimated cost base or production process changes significantly. Reviewing your estimated total overhead costs regularly keeps your overhead rate accurate and supports stronger financial planning and product cost decisions.