Budgeted Factory-Overhead Rate Definition

The budgeted factory-overhead rate is an average overhead rate that you use to calculate the cost of products or services. Budgeted factory-overhead rates are used when fixed costs can’t be directly determined, such as in budgeting and planning activities. Budgeted factory overhead rates are also known as planned overhead rates.

Why Is It Important for a Company to Know Their Budgeted Factory-Overhead Rate

The budgeted factory-overhead rate is important for any business to know because it allows the business owner or managers to create forecasts that are accurate. Budgeted factory overhead rates allow sales and marketing managers to forecast sales, production managers can forecast the cost of goods sold, and finance managers can forecast net income. Budgeted factory overhead rates are also important for business owners to know because the budgeted factory-overhead rate is used in several financial calculations, such as break-even point and cost variance analysis. Also, budgeted factory-overhead rates are used for product costing purposes, including standard costs and variances.

How To Calculate Budgeted Factory-Overhead Rate

You can calculate a budgeted factory-overhead rate by dividing the total expected overhead costs for one period (usually one year) by the number of direct labor hours expected in that period.

Sample Calculation Budgeted Factory-Overhead Rate

Here’s an example of how to calculate a Budgeted Factory- Overhead Rate. Budgeted factory costs are $675,000 for the year, and 1,200,000 direct labor hours are expected. $675,000 Budgeted Factory Costs ÷ 1,200,000 Hours = .05 Budgeted Factory-Overhead Rate

Direct Labor Hours vs Machine Hours vs Budgeted Labor Hours

In some cases, Budgeted Factory-Overhead Rates are calculated using Budgeted Labor Hours instead of Direct Labor Hours. Budgeted Machine Hours or Budgeted Machine Availability may also be used by manufacturing companies. Direct labor hour is defined as the number of hours that workers who are paid an hourly wage work on a project. Budgeted labor hour is defined as the number of hours estimated to be worked by the employees assigned to a specific project, regardless of their wage rate or how many people contribute to the completion of the project. Budgeted machine hours and Budgeted machine availability take into account how much time each machine will be used during the budget time frame.

Why You Should Use Budgeted Factory-Overhead Rate In Your Business

Factors such as industry and business size can affect the level of factory overhead costs. Budgeted factory-overhead rates allow you to:

  • Budget your expected manufacturing overhead costs
  • Apportion business expenses to the appropriate departments
  • Budget for future periods

When Not to Use a Budgeted Factory-Overhead Rate

In situations where factory overhead costs vary from period to period, you might not be able to use a budgeted factory-overhead rate. Companies with significant start-up costs also shouldn’t use a budgeted factory-overhead rate because it isn’t an accurate representation of actual factory overhead costs for the year.

Advantage Of Budgeted Factory-Overhead Rate In Your Business

Budgeted factory-overhead rates provide accurate budgeting figures that can be used throughout the business year. Budgeted factory-overhead rate calculations are objective and precise, while other methods of budgeting factory overhead costs may be less precise and more difficult to monitor.

Disadvantages Of Budgeted Factory-Overhead Rate In Your Business

When using budgeted factory-overhead rates, you should ensure that all costs are included. Budgeted factory overhead rates can’t be determined until the period is over, which means that expenses could be missing from your budget. Budgeted factory-overhead rates also assume that overhead costs remain stable throughout the year—if this isn’t true for your company, budgeted factory-overhead rates may not provide an accurate view of your overhead expenses.

Tips For Calculating The Best Budgeted Factory-Overhead Rate

Calculate the budgeted factory-overhead rate for each department in your business. Although this approach is more difficult to track, it provides better insight into how much factory expenses are being used by each department. Budgeted factory-overhead rates are usually calculated using direct labor hours as the basis for measurement. Budgeting overhead costs based on machine hours is another method to consider, especially for companies that have high volumes of machinery or equipment running during different times throughout the year.

The Bottom Line

Budgeted Factory Overhead Rates are important to know and understand because they affect the calculations and decision-making of accounts payable, finance managers, and business owners. Also, Budgeted Factory Overhead Rates can provide a better understanding of business costs and how they affect the overall financial condition of a company. Budgeted Factory-Overhead Rate is very important and useful especially in budgeting and determining multiple factors such as break-even point and product costing. Budgeted factory overheads rates should be used with precaution though because it is crucial to be able to drive the business successfully by the accurate calculation of it.

The budgeted factory-overhead rate is generally calculated by dividing Budgeted Factory Costs by Budgeted Hours or Budgeted Direct Labor Hours.
The budgeted factory-overhead rate provides the total amount of overhead costs for each labor hour used in production.
Budgeted factory overhead rate can be calculated based on Direct Labor Hours, Machine Hours, and Budgeted Labor Hours.
The budgeted factory-overhead rate helps companies monitor their overhead costs throughout the year which can contribute to future budgeting decisions such as product pricing, operational expense, and manufacturing decision-making.
This can be calculated by (Budgeted Factory Overhead Costs/ Budgeted Labor Hours).

True Tamplin, BSc, CEPF®

About the Author
True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website, view his author profile on Amazon, or check out his speaker profile on the CFA Institute website.