Don’t Bump The Overhead

One client that I worked for a number of years ago had an ongoing argument between the CFO and other members of the Executive Team about overhead. The argument got pretty acrimonious when it came to allocating overhead; everybody wanted it allocated anywhere but to their group! At least they were thinking about overhead.

I have run into a number of companies over the years, in particular small companies that did not pay attention to overhead, and wound up wondering why their bottom lines looked the way that they did.

Allocating overhead can be a very complex issue, so I would like to break it down into some fundamental pieces here, and give you a simple process for making a “ball park” estimate of how overhead may be affecting your company. In particular in small businesses, it is important to get close, but not necessarily down to the penny in order to improve your vision into how your business is functioning.

First, let’s define overhead: overhead may consist of any cost that cannot be allocated directly to the production of your product or service. This may include such costs as rent, electricity and other utilities, as well as the cost of administrative staff and benefits. It should not be hard to look down your Profit and Loss Statement to determine what is directly attributed to producing a product or service and what is not.

In some service companies, in particular consulting companies, your direct costs may be a simple as consulting hours, with everything else being overhead. In a manufacturing company, it may be a bit more difficult when determining whether materials are direct or overhead, the same with machine time, for example. Most important, for those that are just starting determine overhead is to allocate each to a category, either direct cost or overhead (I know, there are those that will now talk about indirect versus direct cost: I want to keep this simple!).

Now that we have all costs divided into the two categories, direct cost and overhead, an easy way to allocate overhead is based on assigning a portion of overhead to each hour worked. For example, let’s take a company with 15 employees; say that 11 are directly involved in creating a product or service and four would be considered management and administration. The overhead may look like this:

Salaries, Benefits, Administrative and Taxes: $150,000
Rent, Utilities and other Costs: $100,000
Total Overhead $250,000

Let’s say that here are 11 employees directly involved in producing a product or service. Let’s say that they work a standard work year of 2,000 hours, or a total of 22,000 hours in a year. We can now determine how much overhead to allocate to each hour worked with a simple calculation: $250,000/22,000 = $11.36 per hour.

To determine the effect of overhead on the company, you would then take the hourly rate for each employee (if they are on salary, that would be their salary divided by the 2,000 standard hours) and the total would give you a fully-loaded hourly cost per employee. You can then compare this cost to what is being billed to the client; either directly or as the part of the cost of a product or service, and see not only if you are only recovering your overhead, but also whether or not you can be profitable at the rate you are charging your customer.

Taking some time to see how overhead is effecting your bottom line can be the difference between a profitable enterprise and one that is being unintentionally “not for profit”.

4 thoughts on “Don’t Bump The Overhead

  1. Great points, Kevin. Gary Sutton in his little book – Corporate Canaries – discussed how you cannot outgrow losses. I will be including your remarks in tomorrow’s blog –

  2. Kevin, great article on how to actually run a business. In my experience, many people are fantastic in their chosen field but they have no more idea on how to run a business than my dog.

    A few years ago I worked with a small company, maybe a total of 60 people. The top management were highkly skilled in their fields, all with top qualifications but had absolutely no idea of how to actually run a business. Organization, communication and collaboration was, except among the 3 heads, absolutely zero. They squandered money relentlessly while complaining that it cost 35 cents a cup for coffee for the office staff. Their answer was to constantly cut staff while continuing their usual practices.

    Never having made a profit since inception many years ago, the company will sadly go where all go under such “leadership”.

  3. […] recent post in the COO Bulldog by Kevin Callahan provided a simple explanation as how to calculate and subscribe overhead costs to […]

  4. kevin coghlan

    Overhead is very important (and sometimes overlooked) business consideration; thanks for the article.

    In the professional services industry, “return on overhead” is gaining some traction as a way to track the contribution of overhead to the success of the enterprise. The total net profits are measured against the total indirect costs (overhead costs) to determine a % return on overhead. From a business owner’s perspective, this metric can be used to determine how will his/her “investment” is doing compared to other investment benchmarks, considering risk tolerance and other modifying factors.

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