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Predetermined Overhead Rate

Predetermined Overhead Rate Definition

A company uses a predetermined overhead rate to allocate overhead costs to the costs of products. Indirect costs are estimated, a cost driver is selected, cost driver activity is estimated, and then indirect costs are applied to production output based on a formula using these data.

Predetermined Overhead Rate Example

For example, imagine a company that makes widgets. In order to make the widgets, the production process requires raw material inputs and direct labor. These two factors comprise part of the cost of producing each widget; however, ignoring overhead costs, such as rent, utilities, and administrative expenses that indirectly contribute to the production process, would result in underestimating the cost of each widget. Therefore overhead costs are allocated to production output via predetermined overhead rates, or rates that determine how much of the overhead costs are applied to each unit of production output.

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Predetermined Overhead Rate Usage

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps for computing the predetermined overhead rate in the traditional costing process, including the following:

1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.

Calculating Predetermined Overhead Rate

First, use the following formula to calculate overhead rate.

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

See the following calculation example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

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Financial Distress Costs

See Also:
Financial Accounting Standards Board
Financial Instruments
Hedging Risk
Financial Ratios
Finance Beta Definition

Financial Distress Costs

In finance, consider a company to be in financial distress when it is having difficulty making payments to creditors. Financial distress may lead to bankruptcy. The more debt a company uses to finance its operations the more it is at risk of experiencing financial distress. There are several costs associated with financial distress, including bankruptcy costs, distressed asset sales, a higher cost of capital, indirect costs, and conflicts of interest.

Bankruptcy Costs

The more debt a company takes on, the more it risks being unable to meet its financial obligations to creditors. A highly leveraged firm is more vulnerable to a decrease in profitability. Therefore, a highly levered firm has a higher risk of bankruptcy.

Bankruptcy costs vary for different types of firms, but they typically include legal fees and, losses incurred from selling assets at distressed fire-sale prices, and the departure of valuable human capital. The way to measure bankruptcy cost is to multiply the probability of bankruptcy by the expected cost of bankruptcy. A company should consider the expected cost of bankruptcy when deciding how much debt to take on.

Indirect Costs of Financial Distress

There are also several indirect costs associated with financial distress. When a company is experiencing financial distress, conservative managers may cut down on research and development, marketing research, and other investments to spare cash. The firm may also incur opportunity costs if trepid managers pass on risky corporate projects.

Also, financial distress can affect a firm’s reputation. A company in financial distress may lose customers, be forced to pay a higher cost of capital, receive less favorable trade credit terms from suppliers, and be vulnerable to tactics from aggressive industry competitors.

Financial Distress and Conflicts of Interest

Financial distress can incur costs associated with the conflicting self-interests of creditors, managers, and owners.

When a company in financial distress is confronted with a risky investment opportunity, creditors would prefer the company not engage in the risky investment – they would rather the company preserve its assets so they will be able to collect what’s owed to them in the event of default or bankruptcy.

Investors, or owners, on the other hand, would prefer the company to go forward with the risky investment. If the company foregoes the investment, owners don’t benefit. If the company does go for the risky investment, owners have at least some upside gain potential.

While managers may be either conservative in the face of a risky opportunity in order to try to preserve their jobs, or they may be more inclined to take the risk if they side with the shareholders or see the opportunity as a chance to increase personal gain.

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financial distress costs

Source:

Higgins, Robert C. “Analysis for Financial Management,” McGraw-Hill Irwin, New York, 2007.

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Direct Materials

See Also:
Direct Cost vs Indirect Cost
Direct Labor
Cost Driver
Direct Labor Variance Formulas
Direct Material Variance Formulas
Absorption Cost Accounting

Direct Materials Definition

In accounting, direct materials are the resources used to make a product. You must clearly link these resources to the product you are producing. Direct material costs are one of the costs associated with producing a product. Furthermore, direct materials are in contrast to indirect materials. Indirect materials are materials used to produce a product not clearly linked or traceable to the final product.

Examples of direct materials include the following:

  • Wood used to make tables
  • Glass used to make windows
  • Fabric used to make furniture

Direct Material and Overhead Allocation

Sometimes it may be appropriate to use direct materials as a cost driver to allocate indirect costs to a production process.

Indirect costs, such as overhead costs, are not directly traceable to the final product; however, they are necessary for the production of the process. Therefore, incorporate them in the overall cost of the product and then allocate them to the final product by way of a cost driver.

In production processes in which direct material is an appropriate cost driver, on can allocate indirect costs to the cost of units of output via direct material. The measurement of the cost driver depends on the type of material. If it’s wood, then the cost driver may be based on feet of wood used, or pounds of wood used.

Using direct materials as a cost driver requires quantifying the direct material with some physical or otherwise quantifiable measure. Then allocate indirect costs to the units of output using a cost driver rate, such as $2 dollars per foot of wood, or $0.40 per square foot of fabric, depending on what direct material you use and the specifics of the production process.

direct materials

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

 

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Cost Driver

See Also:
Cost Center
Value Drivers: Building Reliable Systems to Sustain Growth
Direct Labor Variance Formulas
Direct Material Variance Formulas
Step Method Allocation

Cost Driver Definition

In accounting, the cost driver definition is a factor that incurs cost. Use cost drivers to allocate variable and indirect costs to production activities or output. Include both indirect costs and direct costs to compute the full cost of production. Because indirect costs, such as variable overhead, are not directly traceable to production activities, allocate them according to a cost driver rate to apply these costs to production activities. Based on the activity of the cost driver, the cost driver rate is the rate indirect costs applied to production activities.


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Choosing Cost Drivers

An indirect or variable cost may have several possible cost drivers. Traditional costing methods allocate indirect costs to production activities based on volume of output. Conversely, activity-based costing allocates indirect costs to particular production activities related to that cost.

When deciding which driver to use in terms of allocating indirect cost, consider the cause-and-effect relation between the cost and the driver. In addition, consider whether or not the cost driver activity is easily measurable. It is also necessary to consider the cost behavior of the relevant cost. The relevant cost refers to the cost’s response to the activity of the driver. In addition, approximate the relationship between costs and cost drivers using regression analysis.

Use these drivers at differing hierarchical levels. For example, an indirect or variable cost may be relevant at the unit level, the batch level, the product level, the customer level, or the facility level. Once you determine the appropriate hierarchical level, choose a cost driver activity at that level in order to allocate the indirect or variable cost.

Cost Driver Rates

A cost driver rate is the amount of indirect or variable cost assigned to each unit of cost driver activity. For example, you may apply indirect overhead to direct labor hours as $50 dollars per hour. In this case, for each hour of direct labor required for production, the company would then allocate $50 of indirect overhead costs to the production activities or output.

Cost Driver Examples

For illustrative purposes, below are some cost driver examples of indirect or variable costs as well as relevant cost driver bases for these costs.

CostCost Driver 
Maintenance expenseMachine hours
Fuel costsMiles traveled
Electricity expenseHours of factory operation
Material handling expenseTons of material handled

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cost driver, Cost Driver Definition, Choosing Cost Drivers, Cost Driver Examples

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cost driver, Cost Driver Definition, Choosing Cost Drivers, Cost Driver Examples

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Activity-based Costing (ABC) vs Traditional Costing

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

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Activity Based Costing

See Also:
Activity-based Costing (ABC) vs Traditional Costing

Activity Based Costing

Activity based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs.

ABC is commonly used in the manufacturing sector. A reason why it is so useful for the manufacturing sector is fairly obvious, by allocating indirect costs to products based on usage, a company can more accurately see where the resources and energy is going in their company. By figuring out where the money and energy is going, efforts can be focused upon those products that are eating up the most time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made to reduce the costs on the bulk of the products. Activity based costing is all about efficiency. Efficiency is paramount to success and growth within a company and that is why activity based costing is an effective way to allocate indirect costs within a company to products.

Activity Based Costing Steps

Th four following steps include the activity based costing process:

1. Identify and classify all of the activities in the value chain related to the production of the product.

2. Estimate a total cost for each of the activities identified.

3. Compute a cost-driver rate for each activity based on a cost allocation base that has a causal link to the cost of the activity.

4. Apply activity costs to products using the appropriate cost-driver rate.

Activity-Based Costing Example

For example, a company identifies and classifies machine maintenance as an indirect cost activity. Based on historical data, the company estimates machine maintenance costs to be $1,000 per month. The company determines that batches of product produced on the machine are an appropriate cost-driver allocation base for machine maintenance costs. The machine typically produces 500 batches per month. Thus, the cost-driver rate would be $1,000/500 batches, or $2/batch. So, for each batch of product produced, the company would apply $2 of indirect cost for machine maintenance.

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