Why pre-determined overhead absorption rates are prefered to overhead absorption rates calculated from factual information after the end of a financial period?

Answer 1

Cost of Production: The most important use is Calculation of production cost. Overhead is a cost and thererfore it is one of the determining factors of overheads. For calculation of cost of production (actual) which will be reflected into the Books of account for the year end we will take into account the factual costs but as far as pricing the produced goods and giving quotes to customer we will need to bank upon the predetermined overhead absorption rates.

Guidelines for the Production Department: The production department is one of the major cost centres for any manufacturing company and overheads is a major expense in that department. Proper management of expenses is very important for any organisation to succeed. As overhead is a highly variable cost it is very important to lay a guideline for the production department as to what the management expects them to expend on overheads. It serves as a benchmark and then it lays in the hands of the production employees as to how carefully they manage their expenses on overheads as to remain in lines with management expectations. A certain degree of variance due to uncontrollable factors like rise in electricity charges, rents, rates etc is always tolerated but other expenses which can be controlled need to be properly in line with budgetary allowance. A wider difference between predetermined costs and actual expenditure will lead to differences in the profitability of the company.

Selling Price Calculation: The prime reason for it being that the actual price of supplying the goods to any customer is determined when an order is placed with us, at that point of time the goods have not been produced hence factual rates are not available for us. The selling price of any goods is equal to Cost plus profit. We can exactly calculate how much profit we anticipate but the cost for any goods not produced cannot be ascertained exactly hence the predetermined rates are used. No customer will ever wait for us till the year end so as to provide him with actual supply price for goods supplied to him at an earlier stage.