The cost of manufacturing products includes more than labor, machinery and supplies. Your company has additional overhead for expenses like utilities, loan payments, insurance and lease payments. This overhead can be figured in such a way that you price each product to pay its share of overhead. In other words, this predetermined overhead rate is part of the cost of each product. Your calculations of expenses become much more accurate when you include predetermined overhead.
Estimate of Overhead Expenses
Estimate the coming year's expenses for utilities, insurance, lease payments, maintenance and any expense that occurs no matter how much you manufacture. Include servicing loans and vehicle expenses. You will have to estimate some of these expenses based on previous years' costs plus a percentage added for inflation. If you don't have a previous year to go by, you can use a few months of expenses and estimate what the total expense will be for the coming year.
Total Number of Units
Estimate the number of units you will manufacture in the coming year. Base this estimate on your monthly production rate or, better yet, on last year's production rate. Include any expected increases in productivity due to retooling, incentive programs or improvements in efficiency.
Divide Overhead by Units
You arrive at your predetermined overhead rate by dividing your overhead estimate by the number of units. For example, if you have an estimated overhead of $100,000 and you will make 50,000 units, divide 100,000 by 50,000 and you find that you have $2 worth of overhead expenses in every product. In this case, your predetermined overhead rate is $2 per unit.
You also can use manufacturing hours instead of units to determine your overhead rate. Calculate the total number of manufacturing hours in a year, and divide your overhead figure by the number of hours. The result is the amount of overhead expense you incur for every hour of manufacturing. For example, if you have an overhead of $200,000 and you manufacture for 2,000 hours, divide 200,000 by 2,000 to find that you have $100 of predetermined overhead for every hour you operate.
You can calculate overhead per unit or hour for past years, though technically it can't be called "predetermined." Use the same process, but instead of estimates, use actual production and dollar figures from a previous year. This exercise can help you see if you have been under-pricing your products. On the other hand, you might find you have been charging more than you need to, and you could lower prices to become more competitive.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.