what effect would the change in predetermined overhead rate have on the company's inventory values?
The change in predetermined overhead rate can have an impact on a company's inventory values. To understand why, we need to first understand what the predetermined overhead rate is.
Predetermined overhead rate, also known as the overhead absorption rate, is used to allocate indirect manufacturing costs to the products a company produces. It is usually calculated by dividing the estimated overhead costs by an allocation base, such as direct labor hours or machine hours.
Now, let's consider the effect of a change in predetermined overhead rate on inventory values:
1. Overapplied or Underapplied Overhead: If the change in the predetermined overhead rate causes the actual overhead costs to differ from the allocated overhead costs, it can result in either overapplied or underapplied overhead. Overapplied overhead means that more overhead has been allocated than the actual amount incurred, while underapplied overhead means that less overhead has been allocated. These differences are usually adjusted at the end of an accounting period.
- Impact on Finished Goods Inventory: If there is overapplied overhead, it will decrease the cost of goods sold (COGS) and increase the value of finished goods inventory. Conversely, if there is underapplied overhead, it will increase the COGS and decrease the value of finished goods inventory.
- Impact on Work-in-Process Inventory: If there is overapplied overhead, it will decrease the cost of goods manufactured (CGM) and increase the value of work-in-process (WIP) inventory. On the other hand, underapplied overhead will increase the CGM and decrease the value of WIP inventory.
- Impact on Raw Materials Inventory: Predetermined overhead rate does not directly affect the value of raw materials inventory, as it is considered a direct cost and not an overhead cost.
2. Decision-making: A change in the predetermined overhead rate can influence management decisions related to pricing, product profitability analysis, and future investment decisions. It provides insight into the accurate cost allocation process and helps management make informed decisions.
In summary, the change in predetermined overhead rate affects the allocation of indirect manufacturing costs, resulting in adjustments to the values of finished goods inventory and work-in-process inventory. It is essential to monitor and evaluate the impact of overhead rate changes to ensure accurate cost allocation and informed decision-making.