Actual and Predetermined Overhead | Differences

The basic purpose of overhead absorption rates is to absorb total overhead in products or jobs manufactured. This objective can be achieved through actual overhead rate or predetermined overhead rate.

Actual Overhead Rate:

When the absorption is based on actual overhead, it is known as actual absorption rate. This can be calculated only after the end -of the accounting period when all cost and production figures have been collected.

This method has the following disadvantages:

(1) Product costs cannot be determined until some considerable time after the end of the ac­counting period. This may not help in controlling cost and in fixing selling prices.


(2) There are likely to be variations in the overhead incurred because of the seasonal nature of some overhead costs, change in the volume of production and efficiency of factory for different periods. If actual overhead costs from individual month is used, the overhead cost per unit will vary because of seasonal costs. Where actual costs are used to calculate selling prices, difficulties arise because the product cost fluctuates from period to period and there is a considerable delay in product cost determination.

(3) Some overhead costs are of fixed nature, such as depreciation, supervision, property taxes, etc. These overhead costs being constant give a different per unit cost when divided by differing production volumes. Also some overheads like fire insurance premium are paid in advance but this should be charged to all work done/products manufactured during the year. How should the absorp­tion be done? It creates an inequitable situation.

Similar absorption problems would result if actual cost incurred for repairs and maintenance were charged directly to a job or product processed during the month when the repairs were done. This is not equitable. Ordinarily, repairs are necessary be­cause of wear and tear over a much larger period than one month and are done to permit continuous production.

Predetermined Overhead Rate:

A different overhead cost per unit (higher or lower) is misleading as it prompts one to conclude that management is less efficient in one period as compared to the other. But the variation in total cost and unit cost just reflect the time of year the units were manufactured, a factor outside the control of management. Cost accountants aim to average out these variations through the use of a predetermined overhead rate calculated on an annual basis. All the seasonal overhead costs are merged together and spread over (charged to) the production for the entire year.


Predetermined overhead rate is a rate calculated in advance of the period in which it is to be used, by dividing the estimated period overhead to be absorbed by the estimated period production. Production may be measured on any of the absorption bases, such as prime cost, labour hours, etc. A predetermined overhead rate provides the only feasible method of computing product overhead cost promptly enough to serve management needs and eliminates uncontrollable and illogical month to month fluctuations in unit costs.

Predetermined overhead rates can be used with advantage for both job order and process cost accounting. The primary objective, of predetermined overhead rates is to provide a reasonably constant unit cost and to avoid unit cost fluctuations caused by seasonal overhead cost fluctuations, changes in volume, or accounting methods.

Secondly, predetermined overhead rates also make possible the immediate costing of job or products completed during the month. When a job is finished, the absorption rate is multiplied by the absorption base to find out the total amount to be charged to the product or job. Under a process costing system, predetermined overhead rate is used to charge overhead to the output of the process in question.

Thirdly, predetermined rates contribute effectively to standard costing and budgetary control programmes as these programmes use estimated costs and standard cost to measure production activities.

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