HOW accurate is your company's return-on-investment analysis? That depends largely on how costs for the project are allocated and calculated.
Gordon Treisbach, executive vice president of finance for Reading Equipment & Distribution Inc in Bowmansville, Pennsylvania, tried to ease the intimidating nature of accounting for all the different types of costs when he made his presentation, “Calculating Accurate Burdened Labor Costs,” at The Work Truck Show earlier this year.
Treisbach, filling in for John Puckett — who originally prepared the presentation but was unable to deliver it in Indianapolis — discussed costs associated with wages, salaries, benefits, and overhead, along with methods to incorporate them into the true cost of labor for a business.
The subtitle of Treisbach's presentation — “If you don't know your cost, you're just gambling for profits!” — is a pointed reminder of the critical nature of the topic.
Treisbach said there are three types of costs: direct materials (“which most people can get a good handle on”); direct labor (“sometimes more difficult to get a good handle on”); and overhead (“this mysterious thing that sometimes can be referred to as the hidden cost of doing business”).
He said a company's current labor-costing rate can be average hourly rate, average hourly rate plus benefits, or average hourly rate plus overhead.
“Some people ask, ‘Why do you use an average hourly rate?’” he said. “Occasionally, a salesman will come up to you and say, ‘I sold this job a little thin. I'd like Bill to work on this job, because I knew he makes $10 an hour.’ What's the problem with that? Well, Bill may not be available. We all know how accurate chassis delivery dates are.
“Or at the last minute, if a customer wants to make a change and you have to send it over to manufacturing, you may not get the same delivery you anticipated, and Bill may not be able to do the installation. If we use an average hourly rate, it doesn't make any difference who was going to be doing it. From a cost standpoint, it still costs the same amount per hour.”
He said some people have difficulty in determining what constitutes overhead, but it includes all cost found on the income statement except direct labor, direct material, and cost associated with sales and general administration. In other words, it could include rent, utilities, cost of a forklift, shop supervisor, stockroom employees, or the cost of the employee benefits.
“If you're a distributor, you have welding gas, welding wire, drill bits, insurance, gloves,” Treisbach said. “These are all the things involved in running the installation side of your business that you can't charge directly to a specific job, which could also encompass service or paint.”
He said those who aren't sure whether advertising or training costs are part of overhead should consult their financial advisor. He said advertising typically falls under selling, which is not part of overhead.
“The technical term is ‘period cost,’ and it gets written off every month,” he said. “Training, however, could be part of your overhead. That's another example of a hidden cost of running your business. So much of that training, you could divide that by your base hours and allocate that as part of your hourly rate.”
He said direct-labor employees who do jobs other than direct labor — it could be sweeping the floor or delivering trucks — become part of overhead.
“To do this, you have to keep track of your direct-labor hours,” he said. “You have to have a means to capture that — either a job card or computer program that tells you how many hours you actually charged to jobs. If you don't have the means to actually capture these hours, then you'll be using your best guesstimate.”
Normal activity level
To calculate a shop rate, first calculate the average hourly rate for the direct shop employees. Four employees at $15 an hour and two employees at $12 an hour provides a total of six employees costing $84, which is an average hourly rate of $14.
Then calculate how many hours per month that will involve the direct workers. Six employees working 40 hours a week for 52 weeks totals 12,480 hours a year without overtime. Then deduct the vacation and holidays, since they are really part of overhead. That total — 11,500 hours — becomes the normal activity level.
“Now, in your business, you may use your shop people to also load and unload trucks, or deliver equipment after you've installed it,” he said. “Maybe you're doing low maintenance around the building. You want to deduct that time from 11,500 hours. You only want to use what time you're actually going to be doing installation — time charged to a job. What works for you might not work for someone else.
“Your normal activity level also can be used for production planning purposes. When you think about it, you're not selling dollars. You're selling your shop time. This is the shop time you have available to sell and you want to do this as profitably as possible, and at the same time, know what your cost is.
“These hours can be used to set up a production schedule. You can break this down even farther and say how many hours you have a month or week to sell. That can be modified if you know somebody's going to be on vacation, or you have holidays in a given month or week. This will help you predict better when you can deliver product. We've all had sales people come in and say, ‘I need these 10 units out in March.’ This is a way to say if you have direct hours available to do the installation in any given period.”
The third step involves quantifying overhead. Example: rent $60,000, utilities $25,000, forklift cost $5,000, shop supervisor $75,000, stockroom employees $60,000, employee benefits $74,000, for a total of $299,000.
The fourth step is calculating the overhead rate. Divide $299,000 by 11,500 hours for an overhead rate of $26 an hour. Add that to the direct labor rate of $14 for a shop rate of $40.
Single or departmental rates?
Treisbach said that in order to determine whether a company should use single or departmental rates, it should ask if it has different production departments, such as installation, repair, or paint.
“There's only one way to know that — to actually calculate the rates for each department just as we did for the single rate,” he said. “You may find you have a significant difference from one department to the next. Maybe where you have your installation facility, you may have a master painter who earns significantly more than the installation mechanic. The cost of running the paint department with your spray booth and heating may outweigh what you use for installation. The only way to find out is to actually calculate the rates. Allocation of some costs may have to happen: rent, utilities, supervision, forklift, and employee benefits.”
Allocation is based on three elements:
- Square footage of the area.
“A sample example would be, if your painting foreman takes up 50% of your building, half of the cost of the rent would be allocated to installation and half to the paint department.”
- Number of employees.
“A paint shop has maybe two employees, so maybe they'll get 20% of the shop supervisor. You know your business better than anybody. You know how much time the supervisor spends in each department — and basically, that's what you can use on your allocation, too.”
- Percentage of use.
“It might be a fork truck — how much time it's used in installation as opposed to the paint department. I want to stress there is no ‘exact way’ to do this. Your know your business and what's going to make sense.”
How often should overhead rates be reviewed?
He said overhead rates can fluctuate from month to month.
“The month you send a forklift out for repair, you might have $2000 in your overhead charges,” he said. “You wouldn't want to be reviewing your overhead rate that month.”
He said direct labor hours also can fluctuate, depending on holidays, vacations, sick days, and vacancies. Rates are usually reviewed annually, which negates the month-to-month fluctuations.
Why worry about an “accurate” burdened labor cost? He said it will give you increased knowledge, more accurate costing, more control points, and — the main goal of any business — improved profitability.