1. Introduction and Objectives
Waiting until the end of a fiscal year to determine true overhead costs prevents timely product pricing and profitability analysis. Traditional costing uses a Predetermined Overhead Absorption Rate (OAR) to apply estimated overhead costs to products during the year.
 
2. Formula Architecture
The predetermined rate is calculated before the accounting period begins, using budgeted figures:
OAR = Budgeted Total Manufacturing Overhead Costs / Budgeted Direct Allocation Operational Base Volume
 
3. Selection of the Operational Base
The allocation base should reflect the primary factor driving production in that specific department:
  • Machine Hour Rate: Used in highly automated departments where machine run-time drives indirect costs (e.g., electricity, equipment maintenance).
  • Direct Labor Hour Rate: Used in labor-intensive environments where manual work hours drive support costs.
  • Percentage of Prime Cost: A traditional shortcut that calculates overhead as a percentage of total direct costs. It is simpler but less precise.

 
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