Predetermined overhead rates help companies allocate indirect costs to products before actual costs are known. This method uses estimates of total overhead and production activity to create a consistent rate for assigning costs throughout the period, improving cost control and decision-making.

Calculating total product cost involves combining direct materials, direct labor, and allocated overhead. By understanding cost behavior and using appropriate allocation methods, companies can more accurately determine the true cost of their products, supporting pricing and profitability analysis.

Calculating Predetermined Overhead and Total Cost

Predetermined overhead rate calculation

• Estimates total overhead costs for a future period divides by estimated total units in the allocation base (direct labor hours, machine hours, or direct labor costs)
• Helps allocate overhead costs to products before actual costs are known
• Provides a consistent rate for assigning overhead costs throughout the period
• Allows for better cost control and decision-making
• Example: $\text{Predetermined overhead rate} = \frac{$200,000 \text{ estimated overhead}}{20,000 \text{ estimated machine hours}} = $10 \text{ per machine hour}$

Overhead application using labor hours

• Applies overhead costs to products based on the predetermined rate actual quantity of the allocation base used
• Allocation base is often direct labor hours, representing time spent on each product
• Allows for more accurate costing by assigning overhead based on the resource consumption of each product
• Example:
  • Product X consumes 1,000 direct labor hours
  • Predetermined overhead rate is $20 per direct labor hour
  • $\text{Allocated overhead for Product X} = 1,000 \text{ hours} \times $20 \text{ per hour} = $20,000$

Components of total product cost

• Direct materials
  • Raw materials directly incorporated into the final product (wood, steel, plastic)
  • Traced directly to each product based on the quantity consumed
• Direct labor
  • Wages of workers directly involved in production (assembly line workers, machine operators)
  • Traced directly to each product based on time spent
• Allocated overhead
  • Indirect costs not easily traceable to individual products (rent, utilities, supervisor salaries)
  • Assigned to products using the predetermined overhead rate allocation base
  • Cost allocation methods may include traditional or activity-based costing approaches
• Example:
  • Direct materials for Product Y: $25,000
  • Direct labor for Product Y: $15,000
  • Allocated overhead for Product Y: $20,000 (calculated using the predetermined overhead rate)
  • $\text{Total product cost for Product Y} = $25,000 + $15,000 + $20,000 = $60,000$

Cost behavior and classification

• Variable costs: Change in proportion to activity level (e.g., direct materials)
• Fixed costs: Remain constant regardless of activity level (e.g., rent)
• Understanding cost behavior helps in accurate cost allocation and decision-making
• Cost pools: Groups of individual costs, often used in more complex allocation systems
• Cost drivers: Factors that cause changes in cost, used to allocate costs from cost pools to products