Predetermined Overhead Rate and Cost per Unit


In manufacturing companies, overhead costs are indirect costs that cannot be directly attributed to a specific unit of production. These costs include items such as rent, utilities, and depreciation. To allocate these costs to the units produced, companies use a predetermined overhead rate.


The predetermined overhead rate is calculated by dividing the estimated total overhead costs for a period by the estimated activity level for the same period. This rate is then used to apply overhead costs to the units produced. By doing so, the cost per unit is calculated, which includes both direct costs and allocated overhead costs.


When the volume of production is increased over the level planned, the cost per unit is expected to decrease. This is because the fixed overhead costs are spread over a larger number of units, resulting in a lower cost per unit. Let's understand this in more detail:

1. Fixed Overhead Costs
Fixed overhead costs remain constant regardless of the volume of production. Examples of fixed overhead costs include rent, insurance, and salaries of administrative staff. As the volume of production increases, these fixed costs are spread over a larger number of units, leading to a lower cost per unit.

2. Variable Overhead Costs
Variable overhead costs fluctuate with the volume of production. Examples of variable overhead costs include direct materials, direct labor, and utilities. When the volume of production is increased, variable overhead costs also increase proportionally. However, since these costs are directly attributable to the units produced, the cost per unit remains relatively constant.

3. Allocation of Overhead Costs
When the predetermined overhead rate is not employed, overhead costs are not allocated to the units produced. As a result, the cost per unit would only include direct costs, such as direct materials and direct labor. This means that the cost per unit would not reflect the true cost of production, as it does not account for the indirect costs associated with overhead expenses.


In conclusion, when the volume of production is increased over the level planned and the predetermined overhead rate is not employed, the cost per unit is expected to decrease. This is because fixed overhead costs are spread over a larger number of units, resulting in a lower cost per unit. However, it is important to note that not employing a predetermined overhead rate may lead to an inaccurate cost per unit, as it fails to include the allocated overhead costs that are necessary for a comprehensive analysis of production costs.