Predetermined Rate

Definition

A predetermined rate is a fixed or estimated rate used to allocate indirect costs to cost objects, such as products or services, in a costing system. It is a key concept in the comparison of variable and absorption costing methods.

5 Must Know Facts For Your Next Test

1. The predetermined rate is calculated by dividing the estimated total indirect costs by the expected activity level or volume, such as machine hours or direct labor hours.
2. Predetermined rates are used in absorption costing to allocate indirect costs to products or services, allowing for the full cost of production to be included in the product cost.
3. Predetermined rates can be either a single, plant-wide rate or multiple departmental rates, depending on the complexity of the cost allocation system.
4. Predetermined rates are typically set at the beginning of an accounting period and may be adjusted during the period if significant changes in indirect costs or activity levels occur.
5. The use of a predetermined rate in absorption costing can result in over- or under-applied overhead, which is then adjusted at the end of the accounting period.

Review Questions

• Explain how the predetermined rate is calculated and its purpose in the context of absorption costing.
  • The predetermined rate is calculated by dividing the estimated total indirect costs by the expected activity level or volume, such as machine hours or direct labor hours. This rate is then used in absorption costing to allocate indirect costs to products or services, allowing for the full cost of production to be included in the product cost. The use of a predetermined rate enables the assignment of indirect costs to cost objects, which is a key feature of absorption costing that distinguishes it from variable costing.
• Describe the differences in how predetermined rates are used in variable costing versus absorption costing.
  • In variable costing, only variable overhead costs are included in the product cost, and these are typically applied using a variable overhead rate. In absorption costing, both variable and fixed overhead costs are included in the product cost, and a predetermined overhead rate is used to allocate these indirect costs. The predetermined rate in absorption costing is calculated based on the estimated total indirect costs and expected activity level, whereas the variable overhead rate in variable costing is based solely on the variable indirect costs. This difference in the treatment of indirect costs is a fundamental distinction between the two costing methods.
• Analyze the potential implications of using an inaccurate predetermined rate in an absorption costing system.
  • If the predetermined rate used in an absorption costing system is inaccurate, it can lead to over- or under-applied overhead, which must be adjusted at the end of the accounting period. An inaccurate predetermined rate can result in distorted product costs, potentially leading to incorrect pricing decisions, inefficient resource allocation, and suboptimal managerial decision-making. Additionally, the accuracy of performance evaluations and inventory valuation can be compromised when the predetermined rate does not accurately reflect the actual indirect costs incurred. Careful estimation and periodic review of the predetermined rate are essential to ensure the reliability of the absorption costing system.

Related terms

Indirect Costs:

Costs that cannot be directly attributed to a specific cost object, such as overhead expenses like rent, utilities, and administrative salaries.

Cost Allocation:

The process of assigning indirect costs to cost objects, such as products or services, using a predetermined rate or other allocation method.

Absorption Costing:

A costing method that includes both direct and indirect costs in the cost of a product or service, using a predetermined overhead rate to allocate indirect costs.