A Method of Attributing Overhead

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.

Which Job is Best for Business?

Let’s say we are considering two jobs that are very different. The first we’ll call Custom House. We’ve done a takeoff and we know it totals about 5200 BF, has 50 setups and 75 trusses altogether. The second job we’ll call Straight Run, and what catches our attention is that it too has about 5200 BF. But this job has just one setup and 40 trusses altogether. Straight Run has 2x6 chords, and so the lumber cost is slightly higher than it is for Custom House. We think we can sell Custom House for $8,000 and make about $2800 gross profit. We think we can get $4,900 and in the process, have a gross profit of $750. Which is better for business?

Comparing Work

Let’s put these two jobs side by side to help us with our comparison.

Custom House                                                Straight Run

5200                               BF                                5200

$8,000                            Price                           $4,900

$2,800                            Est. GP                        $750

35%                                Est. GP %                    15%

85                                   Trusses                       40

50                                   Setups                        1

$2,070                            Lumber $                   $2,510

The only thing the two jobs really have in common is the board footage. Which is “better?”

Assumptions

OK, in the current economy we may consider any job we can get as “great.” The biggest problems in recent times have been getting enough work to keep the shop operating and attempting to make any profit - “gross” or otherwise. So for the purposes of this thought experiment, I am making the assumption that we have enough work to keep our shop busy, and we simply would like some way of figuring out, “If I can only get one of these two jobs, which one would I be better off getting?” I will also be making the assumption that our production tables, not our saws, are our “bottleneck.” Stated another way, I am assuming that, “Our ability complete more jobs is limited by the production capacity of our tables.”

What’s Missing

What’s of course missing from the comparison is the time that each job will take to build. Let’s say our estimating system does not tell us how long the work will take at the tables; let’s see if we can create some plausible estimates. With Straight Run, it will take no more than 20 minutes to set up, and about 4 minutes per truss to build. That’s 20 minutes + (40 x 4 minutes) = 180 minutes altogether. In other words it will take about 3 hours of table time to complete the job. For Custom House, the most of the setups will be small changeovers, not a complete re-jigging of the table. So let’s estimate 10 minutes per Setup x 50 setups = 500 minutes. And for building time, 4 minutes per truss x 85 trusses = 340 minutes for a grand total of 840 minutes (or 14 hours) of production time. OK, you can knock holes in my math, but still I think we are coming up with plausible estimate based on reasonable assumptions. You are of course invited to put your estimating routine to work on this problem, if you prefer to do so!

Who’s Better?

The Custom House consumes 14 hours of table time and nets us $2,800; that’s $200 per hour profit. Straight Run consumed only 3 hours of table time and netted us $750; that’s $250 per hour. We are making $25% more profit by doing Straight Run than by doing Custom House. We now see the crucial elements for making good decisions about jobs coming into focus – knowing our costs and coupling them with “what the market will bear” allows us to determine estimated gross profit. If we also know “time consumed to produce,” we can then figure “estimated gross profit per hour.”

Custom House not only used up 14 hours of table time, but I would argue it consumed 14 hours of the business’ time, and is therefore liable for 14 hours worth of overhead as well. More on applying overhead to individual jobs in later articles.

Some Thoughts on Overhead

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.