A default overhead rate is a calculated rate used to assess overhead costs associated with work-in-process inventory, using data on manufacturing and operating costs. It is calculated before production begins to project factors that will affect the inventory and determine changes needed to keep production costs within a certain range. The rate is calculated by estimating the total amount of the activity base, projecting the total manufacturing cost likely to be incurred, and dividing the projected manufacturing overhead costs by the anticipated activity base. This rate is helpful when assessing actual overhead costs is difficult or when planning a project several months before launch.
A default overhead rate is a rate that is calculated to help assess the overhead costs associated with work-in-process inventory. The process of calculating the rate involves several steps, using data that has to do with the manufacturing and operating costs that are associated with the production process. When calculated correctly, this rate makes it easier to understand the amount of overhead involved with actual production, as well as understand all the factors that go into determining the total cost of production.
As the term implies, a predetermined overhead rate is calculated before the actual production process begins. The idea is to make use of the available historical data to project the factors that will apply to the process and how the activity will affect the inventory. Essentially, this type of forward projection can help determine what changes, if any, may be needed to keep production costs within a certain range, or whether making some changes to certain policies and procedures would improve the efficiency of the operation. in a way that would reduce overhead.
While there are several different ways to calculate the default overhead rate, there are three basic steps that are typically involved. Estimating the total amount of the activity base is often the first of these three steps. An activity basis can be the number of direct labor hours involved in the project, machine hours, or even direct labor costs that are anticipated for the project. Once the activity baseline is established, the data is used to project the total manufacturing cost likely to be incurred, allowing for the anticipated level of activity. Finally, dividing the projected manufacturing overhead costs by the anticipated activity base will result in arriving at a predetermined overhead rate for the project.
Using this rate type is often helpful because in some cases it can be difficult to assess actual overhead costs. This is true when trying to start a project that is similar to but not exactly the same as a previous project. Additionally, project planning may occur several months before the actual launch, a situation that allows time for some of the underlying factors to change in some way. Since a default overhead rate is a projection based on available data, it is somewhat more flexible, allowing some allowance for changes in labor costs or the need to replace machinery in the interim to be built into the calculation.
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