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A predetermined overhead rate is a rate that is calculated to aid in assessing the overhead costs related to the work-in-process inventory. The process of calculating the rate involves several steps, using data that has to do with manufacturing and operational costs that are associated with the production process. When calculated properly, this rate makes it easier to understand the amount of overhead that is involved with the 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 available historical data to project the factors that will apply to the process and how the activity will impact the inventory. Essentially, this type of forward projection can aid in determining what, if any, changes may be necessary to keep the production costs within a given range, or if making some changes in certain policies and procedures would enhance the efficiency of the operation in a manner that would reduce the overhead.
While there are several different ways to go about calculating the predetermined overhead rate, there are three basic steps that are normally included. Estimating the total amount of the activity base is often the first of these three steps. An activity base can be the number of direct labor hours involved with the project, the machine hours, or even the direct labor costs that are anticipated for the project. Once the activity base is established, the data is used to project the total manufacturing cost that is 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 type of rate is often helpful because it may be difficult to assess the actual overhead costs in some cases. This is true when attempting to launch a project that is similar to but not exactly like a previous project. In addition, planning for the project may occur several months in advance of the actual launch, a situation that allows time for some of the underlying factors to change in some manner. Since a predetermined overhead rate is a projection based on available data, it is somewhat more flexible, making it possible to build into the calculation some allowance for changes in labor costs or the need to replace machinery in the interim.