In considering a 'better pricing system,' what role should overhead play? Is it necessary to figure out overhead costs? If we've gone through the trouble of figuring out overhead costs, how should we then apply those costs in a price calculations?
Defining Overhead
I'll define overhead for the purposes of this discussion as, "Business costs not being tracked by some other process." The most common "other processes" that are accounted for independently are materials consumed and "direct" shop labor.
This definition leads us to the answer to the question, "What should we include in overhead?" by saying, "Any and all costs that are not being allocated in some other way." If direct labor is part of our pricing system, then overhead should account for everything that is not ‘direct labor.’ If there is no direct labor element to the pricing system, all costs (besides material) are 'overhead.'
Quantifying Overhead
In calculating overhead costs, one method is to move from area to area and make sure costs in each area are included. Beginning with the office, make sure each person and each office expense is included. Next, make sure that all costs associated with running the shop are included. Finally, look at expenses for the overall facility and the business as a whole. An incomplete list would include accounting costs, advertising, banding/strapping cleaning, computers, equipment leases, insurance, markers, office schtuff, subscriptions, telephone, training, travel, uniforms, utilities, vehicles, and waste collection. Have we forgotten anything? By looking through the bills for the month we might catch some things we haven't accounted for. Our goal in this process is to figure out how much money it costs to keep the business open for any given period of time (a month, a day, and hour.)
The Value
The most important reason to do all this is the awareness we gain of what these expenses are, and the realization that these costs are related to time. If the overhead expenses totaled $50,000 per month and we were only open for business for 5 hours a month, we would only have 5 hours to recover, to "pay for," all those overhead costs. If we are "open," or more precisely "producing," for 200 hours per month, we have to somehow "earn" $250 per hour (beyond labor and material) we want to pay for that overhead. This is the reason that the most logical way to apply overhead is based on the amount of time the job will take to produce. The argument goes, "Since overhead itself must be recovered based on how many hours the business is producing each month, the only logical way to assign overhead is based on the time it will take the company to produce each job."
We will look at how to do that in later articles.