Question

1. What is a predetermined overhead rate and explain why many companies use it?

2. Many accountants believe that overhead costs are the main source of product cost distortions. Do you agree or disagree?

3. Explain activity-based product costing.

Answer 1

1. predetermned overhead rate

A predetermined overhead rate is an allocation rate that is used to apply the estimated cost of manufacturing overhead to cost objects for a specific reporting period. In other words, Predetermined overhead rate is used to apply manufacturing overhead to products or job orders and is usually computed at the beginning of each period by dividing the estimated manufacturing overhead cost by an allocation base. Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials.

The formula of predetermined overhead rate is;

predetermined overhead rate   =        Estimated manufacturing overhead cost

         Estimated total units in the allocation base

Many expenses are considered overhead costs, including rent, utilities, depreciation and labor. An overhead rate, or predetermined overhead rate, is an equation that allocates a certain amount of manufacturing overhead to each direct labor or machine hour. This rate helps businesses allocate resources and set pricing.

Using a predetermined overhead rate is advantageous to company planners because it helps them form strategies for the future. Using this calculation gives the best possible estimation of costs based on relatively comfortable overhead estimations. If a business uses an actual overhead cost, they would not be able to determine true costs until after the production has actually happened.

Another tremendous advantage for companies using the predetermined overhead rate is it provides a more consistent analysis even during periods of season variability. Costs to heat and cool a building will vary depending on the time of year, and it is possible that materials costs can increase or decrease during the year depending on the type of product being produced. The predetermined overhead rate takes these variations into consideration and offers a more dependable estimation.

Most companies will adopt the use of predetermined overhead rates in order to know how their products are performing even before the accounting period ends. It is a way to constantly evaluate the profitability of manufacturing instead of waiting until that reporting period comes to an end.

The companies use predetermined overhead rates rather than actual manufacturing overhead costs to apply overhead to jobs because the management requires the overhead rate before year end and the predetermined overhead rates are helpful in record keeping as well.The actual overhead rate does not take into account all the abnormal factors while the predetermined overhead rates include all the abnormal factors related to a particular job.

2. I agree ,that overhead costs are the main source of product cost distortion.

Overhead Cost refers to the cost of indirect material, indirect labor and other operating expenses which are associated with the normal day to day running of the business but cannot be conveniently charged directly to any specific product or service or cost center.

exanples of overhead cost ;

• Accounting and legal expenses.
• Administrative salaries.
• Depreciation.
• Insurance.
• Licenses and government fees.
• Property taxes.
• Rent.

when these overheads increases , it will adversely affect the total product cost or per unit cost of product.

3. Activity based costing

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

in other words,

The activity-based costing (ABC) system is a method of accounting you can use to find the total cost of activities necessary to make a product. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.

Many businesses use the cost of goods sold (COGS) to determine how much it costs to create a product. But, COGS focuses on direct costs and does not include indirect expenses like overhead.

Some businesses take their overhead expenses and allocate them evenly among all products. But because some products use more overhead expenses than others, the cost of making each product is inaccurate under this method.

activit based costing steps;

To use activity-based costing, you must understand the process for assigning costs to activities.

First, identify which activities are necessary to create a product.

Then, separate each activity into its own cost pool, which is a group of individual costs associated with an activity. Determine the total overhead of each cost pool. For example, purchasing could be its own cost pool.

Next, assign activity cost drivers to each cost pool. Cost drivers are things (e.g., units, hours, parts, etc.) that control the changes in costs. For example, purchasing costs are driven by the number of parts purchased.

Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate.

Lastly, compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver rate.

ABC systems can be complicated. Check out this example to help further illustrate the process.