In an earlier article I described what a better pricing model might look like and in another defined in very general terms what “overhead” means within a component manufacturing company. Suggesting a way to put the two together will be the purpose of this article.
In my Technical Support days I used to help explain to component manufacturers how the costing part of the design software worked. Setting up the materials with their proper costs was straightforward, and I could get through the labor estimation with its “setup” and “run” factors without much of a problem. With overhead, the program seemed to want a percentage of something – of material or sale price. We’ll go a different direction and describe a method of attributing overhead based on time.
Two Bins
Let’s say we’ve looked at our business and have put our costs into two large bins. Into the ”direct” bin we’ve put the shop labor, everything that goes into the actual manufacturing process. Into the “overhead” bin we’ve put everything else: rent, office salaries, taxes, and a whole lot more. The important thing is that every cost be accounted for in one of the two bins. The overhead is then added up and converted into a total dollar figure “per month.” Let’s say our figure adds up to $52,000 per month.
Total Direct Hours
Next, we look at the production workforce; everyone who helps us produce deliverable product. Let’s say that’s 18 people, including people who saw, catch, move, build, and stack. Now we’ll multiply the number of people by the number of hours we are working. If we are not too busy and not working overtime, that would be 8 hours x 18 people x 22 working days per month = 3168 hours per month. We need to double check this against the payroll to make sure that that’s about the total number of hours we are actually paying people.
A Labor Model that Estimates Time
Here is the hardest part. We want to create a labor estimating routine that accounts for every part of the direct labor that is being used, and we want it to come very close to predicting what labor we end up actually using. At the end of the month (week, day,) we want the total hours that we thought we would use up (using our labor model) to add up to the hours that we will actually be paying people for. This will be challenging at first if we have been using a very simple method to estimate labor costs, but it is far from impossible. We begin by looking at each activity that people are involved with and provide our initial “best guess” as to the time that the activity will take “per” something – per piece or per truss or per plate. We then apply it to all the jobs we did in a given day or week and see how it compares to the “real” time. We adjust, refine, and through the process learn more about our how our people are actually working. We won’t actually use this labor model until we are confident that can reasonably accurately predict our real production on every job, and very accurately predict our real production over many jobs. Nothing good comes easy and this is where the real work – and reward – of this process will come from.
The Endgame and the Big Payoff
Back to overhead. You’ve calculated that your overhead is currently $52,000 per month and your direct hours add up to 3168. That works out to an overhead of $16.41 per direct labor hour. Now, when calculating the cost of a job you will tally the materials, direct labor, and, using the formula we’ve just created, add an overhead cost equal to $16.41 x the number of direct labor dollars that job is expected to consume. If you estimate the job will consume 100 hours of that precious 3168 hours you have to build things with every month, the job needs to “pay back” $1641.00 to pay for its share of the overhead. You’ve identified your break-even point (congratulations!) and with that comes a lot of power to intelligently decide what jobs to take and which to let go.