Fixed vs. Variable Overhead: Do You Know the Difference?
Since improper labor pricing is the single biggest reason why companies go out of business today, proper labor pricing should be your No. 1 priority.
Our objective over the past several months has been to help you through the process of determining what hourly rate you need to charge to cover your cost of doing business while generating the profit you desire. We started four months ago by talking about equipment replacement costs. Next we discussed field labor and how to determine our cost of nonbillable time. Two months ago, we discussed materials and their respective markups and last month we covered company matching taxes. If you have not read the first four articles and filled out the worksheets, I would strongly suggest you do that before reading this article as each is a piece of the puzzle. Without all the pieces, the process doesn't make much sense and you will not develop the correct hourly rate for your company.
Now it's time to take all the pieces we have created and put them together to determine what our total "real" cost of doing business is. Another name for the cost of doing business is overhead. There are two types of overhead-fixed and variable. Fixed overhead costs are those costs like rent, utilities, basic telephone, loan payments, etc., that stay the same whether sales go up or down. Variable overhead, on the other hand, are those costs which vary directly with production. If production (sales) go up, the variable overhead cost goes up. If sales go down, the variable overhead goes down. Examples of variable overhead would be gasoline and maintenance on vehicles. If you run more calls, then you're on the road more. Sales go up, but so does gasoline and maintenance on the trucks.
As you fill in the worksheets, do it from the perspective of how you would like things to be, not necessarily the way they really are. In the future, we will be talking about net profit. At that time, I'm again going to ask you to build in the profit you would like to have. The idea is quite simple. Let's build our model company the way we would like it to be to determine what hourly rate we would need to charge to make it happen. When it is completed we may not be able to charge what we would like to charge, but let's at least find out what the hourly rate would need to be to "make it happen.".
You will notice there are three worksheets with this article, Worksheets 5, 6 and 7. The first two deal with fixed overhead and the third with variable overhead. As you look at each sheet, use it as a guide. If the cost applies to you, fill it in. If it doesn't, leave it blank. Most of you will have at least a few items that do not appear on the three sheets. If that is the case, use one of the blank lines and fill in the heading with the amount for the year. Before you begin filling out the worksheets, I want to touch on a few specific items. The first item we need to discuss is Owner's Salary. If the owner of the company works full time in the field then they should already be on the field labor sheet we filled in earlier. Don't put your salary in here again. If half the owner's time was in the field then the half that was not on the field labor sheet goes under Owner's Salary. Be sure to include an increase over and above what you are now making. No matter what you are currently making, give yourself a raise! Secretary/Clerical is another thing we need to talk about. It is not unusual for the owner's spouse or other members of the family to be working in the business but be earning little or no salary for doing it. Put in what that person "should" be making-again so we can find out what we would have to charge in order to actually pay them that amount. Add the owner's salary, secretary/clerical help and the cost of nonbillable time together and multiply the total by your matching tax rate on Worksheet 4, item K.
The cost of nonbillable time has already been calculated. If you refer to Worksheet 2, item G you can simply write the number in here. The next line says matching taxes on the above. This is where we fill in the matching tax rate you calculated last month. Now add all the salaries, plus the cost of nonbillable time, together and multiply it by the matching tax rate. The result will be the taxes the company will need to pay for those items. If you are confused on this one read the note at the bottom of the Worksheet 5. The rest of the items on Worksheet 5 are pretty self-explanatory.
Now let's move onto Worksheet 6. Under office expenses you will notice two things. First there is an item entitled Bad Debt. Everyone has somebody that doesn't pay during the year. Put something in this space. Let every customer pay a small portion of your bad debt. If you don't incur any bad debt during the year you simply made a little more money! The item after that is entitled Total Estimated Cost of Customers Using Credit Cards for the Year. As most of you know, you are not allowed to charge your customer for the fee you pay for offering credit cards-at least not directly. You can, and should, however charge them indirectly. Simply estimate what you will pay for the year by letting your customers pay with a credit card and list the total cost on the sheet. Then it becomes part of your hourly rate and everyone pays a small piece of it.
If you build in the 2 to 3 percent on everything you sell during the year that will let you offer a 1 to 3 percent discount for your customers that pay cash! That will help your cash flow. The next item of significant interest deals with loans. If you have a $500 a month loan payment with $100 being interest and $400 principle the only thing that shows up on your accounting income statement is the $100 interest. From a cash flow standpoint, however, you wrote a check for the full $500. It flowed out of your company. When it comes to loan payments be sure you list the full amount (principle and interest) of the monthly loan payment times twelve, on the sheet.
The next big item is Equipment Replacement Cost. This cost was also calculated earlier. Please refer to Worksheet 1 and take the total equipment replacement cost and insert it here. It is item A on Worksheet 1. Now total all of your costs on Worksheets 5 and 6 and put the total fixed overhead cost amount at the bottom of Worksheet 6, item L.
Now let's move onto Worksheet 7 on variable overhead costs. The first items deals with payroll taxes on the chargeable field labor. On the previous worksheet we picked up the taxes on the nonbillable time. Now we are going to calculate the taxes on the billable hours. This figure is arrived at by taking the information on Worksheet 2 and multiplying the average hourly rate times the billable labor hours times the matching tax rate. When you have that number, insert it on the top line. Again, there is an explanation at the bottom of the worksheet. When you have finished filling in all the spaces that apply, total the dollars for Variable Overhead and put the total Variable and total Fixed Overhead costs at the bottom of the sheet and add them together. We now know what it costs to be in business. Kind of scary isn't it?
Now just for fun, take your Total Overhead Cost and divide it by your estimated gross sales. When you do you will have a figure representing overhead as a percentage of gross sales. The number should be somewhere around 28 to 32 percent. Any number much higher than 36 to 38 percent represents an overhead that is significantly out of line.
Now I will admit this month's article may not have been as much "fun" as the past ones, but it is just as necessary. Next month we will continue the process of turning our "real" cost of doing business into what we have to charge per hour to cover that cost while still generating a reasonable profit.
"This article was originally posted on ww.reevesjournal.com."