I was trying to determine why a client was not achieving realistic profits. When I asked the owner to calculate the company’s overhead cost per hour we found that it was very high. This was the root of the problem. Now we could take the proper steps to be competitive and earn a reasonable profit.
Here’s the reason for knowing your overhead cost per hour:
Assume your company’s overhead cost per hour is $50 per hour and your competitor’s overhead cost per hour is $25 per hour. If it takes one hour to produce a product, then you must add $50 to the cost of the product. Your competitor only adds $25. They can sell the product at a lower price.
Or for service companies, say for every 8-hour project your overhead cost is $400 and your competitor’s cost is $200. Your competitor can sell the project for at least $200 less than you can.
How can that be when labor costs are about the same? Material costs are about the same, gas prices are about the same, and insurance costs affect everyone, right?
If your overhead is too high because of spending too much on extras and fancy offices, that can easily be resolved. However, if you’ve cut your overhead to the bone, then you must look other places.
Let’s assume that your overhead costs are similar. Then, if your competition is spreading his overhead cost among four revenue-producing employees and you are only spreading it between two employees, your competition has a lower cost per employee.
Or, if your competition’s sales volume is two to three times higher than yours, your competition’s overhead per sales dollar is much lower than yours.
So, what do you do about it? First, you need to know what your overhead cost per hour is. For smaller companies with a single product line or service, take the year end overhead and divide it by revenue producing hours or billable hours.
If your company has several departments, the best way to determine the overhead cost per department is based on space costs and labor cost, because they are the two components that create overhead.
Departmentalization can be the greatest source of discussion and disagreement amongst owners and managers. I’ve had managers in a room fighting over the number of dollars that they are going to have to pay for each overhead item. How do you calculate overhead per department so that each department gets its fair share of the amount of overhead that should be allocated to that particular department?
Some business owners just take the division of sales and allocate overhead by sales. This is not fair to all departments. Very simply, if you have two departments each generating $1,000,000 in sales and one department has 2 employees generating those $1,000,000 in sales, while another takes 8 people to generate that same $1,000,000 in sales, the department with 8 employees probably consumes more overhead. However, if you calculated overhead by sales in this case, each would get 50% of the overhead, which means that the department with 2 employees would be getting more overhead than it should and the department with 8 employees would be getting less overhead than it should. That’s why you don’t departmentalize by sales volume.
First, the space issues. There are only five things that cause space expenses: rent, utilities, building maintenance, building taxes, and building insurance. Determine the total amount of productive space used by each department. Productive space is the space occupied by either people or things related to revenue producing departments. For example, your bookkeeping space doesn’t count; neither does your reception space. The space that is used by financial people or other people who are not out producing revenues does not count in this equation. The only spaces that count or should be accounted for are those related to service, new construction, replacement, or whatever departments you have. Anything that is common areas or areas used by bookkeeping (areas that are overhead personnel using space) you don’t count.
For example, if you have a 5,000 square foot building and of that 5,000 square feet, 1,000 are being used by Department 1 and 3,000 are being used by Department 2, that is a total of 4,000 square feet that are productive. 25% of the space overhead costs are assigned to Department 1 and 75% of the space related overhead costs are assigned to Department 2. If rent is $1,000 then Department 1 gets $250 for rent and Department 2 gets $750.
Next, people overhead. Every other overhead item is really related to people. The more people you have the more office supplies you have. The more people you have the more telephone calls that you have. If you know the exact amount of time that somebody spends in a particular department, then take that percentage rather than the overall estimate. The first time you calculate people overhead you might not have a clue as to the splits so use the method described below.
If things are bought only for one department then that department gets 100% of that expense. For example, specific product advertising. Other departments producing different products cannot benefit from this advertising. So the cost goes into the department producing that product.
For other overhead items that are split, determine the total amount of productive payroll, i.e., field personnel payroll. Then, if the total productive payroll is $100,000 and Department 1’s productive (revenue producing) payroll is $60,000 and Department 2’s revenue producing payroll is $40,000, then Department 1 gets 60% of people overhead expenses and Department 2 gets 40% of people overhead expenses. If the receptionist’s salary is $500 per week, then Department 1 gets $300 per week expense and Department 2 gets $200 per week expense.
Once you know the total amount of overhead for each department, calculate the cost per hour.
The overhead cost per hour is the total overhead cost divided by the total number of productive hours in that department.
Knowing your overhead cost per hour is the first step to ensuring that all of your overhead costs are accounted for in your pricing. If it is higher than you think it should be, take steps to decrease it so that your company can be more profitable.