Cost accounting is an essential aspect of business operations. To effectively manage costs, businesses need to employ various costing methods. One such method is known as the predetermined cost method. This method uses predetermined costs to estimate the cost of producing goods or services. In this blog, we will discuss the predetermined cost method, its benefits, and how to calculate predetermined costs.
What is Predetermined Cost?
Predetermined cost is a method of calculating the cost of producing goods or services by estimating the cost of each product or service in advance. This method is used to assign costs to each unit of production based on estimates of the costs that will be incurred during the production process. The predetermined cost method is a useful tool for businesses that want to track their costs accurately and make informed decisions about pricing and profitability.
Benefits of Predetermined Cost Method
The predetermined cost method provides several benefits to businesses. One of the most significant benefits is that it allows businesses to estimate their costs accurately, which helps them make informed decisions about pricing and profitability. By knowing the cost of producing each unit of production in advance, businesses can set their prices accordingly, ensuring that they are earning a profit on each unit sold.
Another benefit of the predetermined cost method is that it provides businesses with a basis for comparison. By comparing the actual cost of production to the predetermined cost, businesses can identify areas where they may be overspending and take corrective action.
Calculating Predetermined Cost
To calculate predetermined costs, businesses need to estimate the costs that will be incurred during the production process. The following are the steps involved in calculating predetermined costs:
Step 1: Estimate Direct Materials Cost
The first step is to estimate the cost of direct materials that will be required to produce the product. This includes the cost of raw materials, packaging, and other supplies.
Step 2: Estimate Direct Labor Cost
The next step is to estimate the cost of direct labor that will be required to produce the product. This includes the cost of wages, salaries, and benefits for employees involved in the production process.
Step 3: Estimate Overhead Cost
The final step is to estimate the overhead cost that will be incurred during the production process. This includes the cost of rent, utilities, equipment maintenance, and other indirect costs.
Once these estimates have been made, the predetermined cost can be calculated by adding the estimated direct materials, direct labor, and overhead costs.
Predetermined Cost = Estimated Direct Materials Cost + Estimated Direct Labor Cost + Estimated Overhead Cost
Conclusion
The predetermined cost method is an effective costing method that allows businesses to estimate their costs accurately and make informed decisions about pricing and profitability. By estimating the costs that will be incurred during the production process, businesses can assign costs to each unit of production, making it easier to track costs and identify areas for improvement. With its many benefits, the predetermined cost method is a useful tool for businesses of all sizes and industries.
