DEFAULT COSTS: SYSTEM, ADVANTAGES, DISADVANTAGES - DUDAS - 2025

The cost defaults are projected cost estimates makes a manufacturing company. They are carried out even before starting the manufacture of a product. Sometimes they can also be called standard costs.

The calculation for the predetermined costs is done on the basis of the various variables that affect production, such as raw material, labor, factory expenses, etc.

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At the most basic level, a default cost can be created simply by averaging the actual costs for the last few months. In many companies, this is the system used for analysis.

However, there are some additional factors to consider, which can significantly alter the default cost to use, such as speed of machine setup, changes in labor efficiency, etc.

Importance

The idea behind calculating the default costs is to be able to better understand the budget that will be required to manufacture a product. Also to warn, after production has been completed, if the company has performed better or worse than what was budgeted, or if any variation is found.

In this way, if this occurs, the necessary corrective actions will be taken so that the same error is not repeated again.

Default costs are often part of a manufacturer's annual profit plan and operating budgets. Default costs will be set for direct materials, direct labor, and manufacturing overhead for the following year.

What is a predetermined cost system?

In accounting, a predetermined cost system is a tool for planning budgets, managing and controlling costs, and evaluating expense management performance. It involves estimating the resources required in a production process.

Before the start of an accounting period, standards are determined regarding the quantity and cost of direct materials required for the production process, and the quantity and rate of payment of direct labor required for it.

These established standards will be used to budget for the production process. The predetermined costs of the manufacturing activities will be recorded in the inventories and in the expense account of merchandise sold.

At the end of the accounting period, the actual quantities and costs of the direct material are calculated. The actual amounts and rates of direct labor pay are then used to compare them with the predetermined costs previously established.

Cost variation

There are likely to be some discrepancies between the cost estimate and the actual expenses. The difference between the default and actual manufacturing costs is known as the cost variance. This will be recorded separately in the variation account.

Any balance in a variance account indicates that the company is deviating from the actual amounts in its profit plan.

By comparing actual costs to predetermined costs and examining the variances between them, managers are allowed to look for ways to improve expense control, expense management, and operational efficiency.

Default overall cost

The most noteworthy default cost for an organization is the default overall cost rate. Before the start of each financial year, it is imperative that the organization has determined it. The reason is the typical nature of the overhead.

Other costs can be associated with shorter periods, such as direct operating expenses, salaries (monthly or daily), or the salary of managers (monthly).

However, the overhead costs related to running a plant or business are activities that occur throughout the year. Therefore, they must be predetermined for the correct allocation of the budget. The following formula is used to determine the default overhead:

Default Overhead Rate = Estimated Total Annual Overhead Cost / Estimated Total Activity Base.

The total activity base includes all activities related to overhead costs: amount of labor and machine hours.

Advantage

The default cost system and related variances are a valuable management tool. When a variance arises, management observes that the actual manufacturing costs differ from the predetermined costs.

If the actual costs are greater than the predetermined costs, the variance is unfavorable, indicating that if everything else remains constant, the firm's actual profit will be less than planned.

If the actual costs are less than the predetermined costs, the variance is favorable, indicating that if everything else remains constant, the actual profit probably exceeds the planned profit.

Budget

A budget is always made up of predetermined costs, as it would be impossible to include the exact actual cost of an item on the day the budget is finalized.

Additionally, since a key application of budgeting is comparing it to actual results in subsequent periods, the guidelines used in it continue to appear in financial reports throughout the budget period.

Inventory cost

It is extremely easy to print a report showing the inventory balances at the end of the period, if you are using a perpetual inventory system. This is done by multiplying it by the predetermined cost of each item and instantly generating an ending inventory valuation.

The result doesn't exactly match the actual cost of inventory, but it's close. However, if actual costs are continually changing it may be necessary to update the default costs frequently.

It's easier to update the higher costs of inventory items on a frequent basis, and leave lower-value items for occasional expense reviews.

Price formulation

If a business deals with custom products, it can use the default costs to collect projected expenses from a customer's requirements, after which a margin is added for a profit.

This can be a fairly complex system, where the sales department uses a database of item costs, which change depending on the number of units the customer wants to order.

This system can also account for changes in the company's production expenses at different volume levels, as it may require the use of longer production runs, which are less expensive.

Disadvantages

Implementing a predetermined cost system can be time consuming, labor intensive, and very expensive.

Cost plus contracts

If you have a contract with a customer where the customer pays the costs incurred plus a profit, known as a cost plus contract, then actual expenses must be used, according to the terms of the contract. Default costing is not allowed.

Inappropriate handling of activities

A series of reported variances under a predetermined cost system can lead to incorrect actions to create favorable variances.

For example, raw materials can be purchased in larger quantities to improve purchase price variation, even though this increases inventory investment.

Similarly, longer production cycles can be scheduled to improve labor efficiency variation, although it is better to produce in smaller quantities and accept lower labor efficiency.

Fast paced changes

A predetermined cost system assumes that costs do not change much in the short term, so these standards can be relied upon for several months or even a year before updating costs.

However, in an environment where product lives are short or continuous improvements reduce expenses, a predetermined cost can become out of date within a month or two.

Slow feedback

A complex system of variance calculations is an integral part of a predetermined costing system, which is completed by the accounting staff at the end of each accounting period.

If the production department focuses on immediate feedback on problems to make an instant correction, the reporting of these variations will come too late to be useful.

Unit-level information

The variance calculations that normally accompany a default cost report are accumulated together for the entire production department of a company.

Therefore, they cannot provide discrepancy information at a lower level, such as a particular work cell, batch, or unit.

Examples

Suppose that a company's expense accountants are using default costs. By doing so they will obtain the following data:

- A predetermined cost for each input unit. For example, $ 20 for every hour of direct work.

- A predetermined quantity of each input for each output unit. For example, two hours of work to produce each unit.

- A predetermined cost for each production unit. For example, $ 20 x 2 hours = $ 40 of direct labor for each unit produced.

ABC Company

Company ABC wants to estimate and allocate overheads, such as rent, utilities, and property taxes, to production processes that use these costs indirectly.

Since these costs cannot be calculated arbitrarily, a rate must be used.

The default overhead rate formula is calculated by dividing the estimated total overhead for the period by the estimated activity base.

Direct labor can be taken as an example. Suppose direct labor costs for the next period are estimated to be $ 100,000 and total overhead costs to be $ 150,000.

The default rate would be equal to 1.5. This means that for every $ 1 of direct labor cost, $ 1.50 of overhead will be used in the production process.

Now you can estimate the total overhead required for a job or even make competitive bids.

For example, suppose the company is offering a job that takes $ 5,000 in direct labor costs. You can estimate your overhead costs at $ 5,000 x 1.5 = $ 7,500 and include this as your total bid price.

References

1. Vinish Parikh (2012). What is Predetermined Cost. Lets Learn Finance. Taken from: letslearnfinance.com.
2. My Accounting Course (2019). What is Predetermined Overhead Rate? Taken from: myaccountingcourse.com.
3. Harold Averkamp (2019). What is a standard cost? Accounting Coach. Taken from: accountingcoach.com.
4. MBA Skool (2019). Pre-Determined Cost. Taken from: mbaskool.com.
5. James Wilkinson (2013). Standard Costing System. The Strategic CFO. Taken from: strategiccfo.com.
6. Accounting Tools. Standard costing. Taken from: accountingtools.com.