Three primary reasons exist for using predetermined overhead rates in product costing.
First, a predetermined rate allows overhead to be assigned during the period to the goods produced or services rendered. Thus, a predetermined overhead rate improves the timeliness (though it reduces the precision) of information.
Second, predetermined overhead rates compensate for fluctuations in actual
overhead costs that are unrelated to activity. Overhead may vary monthly because of seasonal or calendar factors. For example, factory utility costs may be highest in the summer. If monthly production were constant and actual overhead were assigned to production, the increase in utilities would cause product cost per unit to be higher in the summer than in the rest of the year. If a company produced 3,000 units of its sole product in each of the months of April and July but utilities were $600 in April and $900 in July, then the average actual utilities cost per unit for April would be $0.20 ($600 : 3,000 units) and $0.30 ($900 : 3,000) in July. Although one such cost difference may not be significant, numerous differences of this type could cause a large distortion in unit cost.
Third, predetermined overhead rates overcome the problem of fluctuations in
activity levels that have no impact on actual fixed overhead costs. Even if total production overhead were the same for each period, changes in activity would cause a per-unit change in cost because of the fixed cost element of overhead. If a company incurred $600 utilities cost in each of October and November but produced 3,750 units of product in October and 3,000 units of product in November, its average actual unit cost for utilities would be $0.16 ($600 : 3,750 units) in October but $0.20 ($600 : 3,000 units) in November. Although one such overhead cost difference caused by fluctuation in production activity may not be significant, numerous differences of this type could cause a large distortion in unit cost. Use of an annual, predetermined overhead rate would overcome the variations demonstrated by the examples above through application of a uniform rate of overhead to all units produced throughout the year.