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Overhead per employee

Question
Does anyone have a good working formula for overhead per employee? If
you normally have five employees, for example, and your overhead is
figured for that, what do you do if you hire two more? You could wait a few
months to come up with a new average, but you might lose money without
knowing it during that time.

Forum Responses
From contributor D:
There are two ways to calculate overhead. One is to use historical data
you've collected and determine what percentage of sales your overhead is.
You then use this percentage when calculating your pricing.

The other method is to use an overhead factor, which is to take your actual
amount of overhead and recover it through the number of man hours
worked on an hourly, daily or monthly basis.

Using either method, if you've added employees, you've probably
(hopefully) increased sales and your overhead as a percentage of sales
should have gone down. Overhead is a constant, and not likely to change
by simply adding a few employees.

Using method one, you would lower the markup percentage that you're
currently adding to your bids.

Using method two, you would lower the dollar amount that you attribute to
each man hour worked.


From contributor B:
I would like some feedback on this issue too. I tend to disagree that adding
employees doesn't add to overhead. Every time we add an employee, we
need to purchase more small equipment, insurance, etc.... It's not HUGE,
but it is there. What is typically included in an overhead figure? Is this
separate from employee benefits (insurance, workers compensation, taxes,
401k, social security, etc.)?

Also, we have a wide range of pay for our cabinetmakers. Do you average
the pay to determine a wage rate? Or do you try and break down averages
for lead men vs. helpers vs. finishers, etc?

Do you put ALL of your overhead towards employees? We allocate a
certain amount of overhead to material markup, and the rest towards "shop
burden" on employees.


From contributor D:



1 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


You said, “I tend to disagree that adding employees doesn't add to
overhead. Every time we add an employee, we need to purchase more
small equipment, insurance, etc.”

If hiring two new employees requires you to increase the size of your
dumpster, or requires you to buy more small tools which you have
categorized as an overhead expense, or if you had to hire a new human
resources manager for the office, your overhead would go up and you
would need to recalculate it. In my shop, however, fluctuations of one or two
employees would not affect any of these things or cause my insurance to go
up.

You asked, “What is typically included in an overhead figure? Is this
separate from employee benefits (insurance, workers comp., taxes, 401k,
social security, etc.)? “

I don™t offer 401k, so I can™t comment on that, but all of the other expenses
you™ve listed are categorized as payroll expenses on my books, not
overhead. Therefore, adding or subtracting employees does not affect my
overhead.

You asked, “Also, we have a wide range of pay for our cabinetmakers. Do
you average the pay to determine a wage rate?”

The wage differences for my shop employees varies by only $2, so yes, I
average their pay rates into one shop rate. Other shops, I believe, charge
different rates for apprentice and journeyman cabinetmakers, as you stated.

You asked, “Do you put ALL of your overhead towards employees? What
about material markup? We allocate a certain amount of overhead to
material markup, and the rest towards "shop burden" on employees.”

Our overhead expense is recovered entirely through our shop rate. When I
calculate a price, I am determining the amount of materials and the amount
of man hours required to perform the job. After calculating this subtotal, I
then add a markup for profit, so I am earning equal profit on materials, labor
and overhead.


From contributor A:
This works for me, but I can't say it will for you. I define overhead to be the
annual costs to be in business, regardless of if someone is working or not.
This includes, but is not limited to rent, salaried employees, property and
liability insurance, utilities, loans including equipment, property taxes. I do
not include hourly employees, workers comp and other employee benefits
unless tied to a salaried position because I only assume those costs if an
employee actually works. I place these figures in the cost of an hour.

I then take the total cost of my overhead and divide it by the number of
hours worked by my production employees. This gives me a cost of
overhead per man hour. I then add that to the cost of an employee per hour,
then place a markup that I want to make on top. If I add all the employees™
costs with markup and overhead in it, then divide by the number of
producing hours, that gives me an hourly shop rate to charge. I can adjust
accordingly if I want. This works for me as a three-man shop. I can't say it
will for anyone else. I don't add materials into the mix because I mark them
up individually and they resolve themselves when I buy and then sell them. I
don't carry a lot of inventory, so it isn't a static overhead expense.

I think what also plays into this is how people price products. I price based
on time, material and expense, for the most part. I don't just mark up
materials a percentage and charge that, though some do.

I think it would be interesting to see how people come up with their charge
rate and how they take various costs into account in determining pricing. I'm
sure a lot of people aren't willing to divulge that information, but I might be
willing to post a sample of what I do for conversation and feedback. I'll talk



2 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


with my partner and see how he feels about it.


From contributor B:
Contributor A, we have more like 18-20 cabinetmakers/finishers, so
changing a couple employees makes a difference, but the additional small
tools, insurance, etc. is inconsequential to the decrease in "shop burden"
per employee. The larger you get, the less it makes a difference, though!
(Adding one employee to a three-man shop will lower the cost/hour more
than adding one to a 20-man shop).

Your formula makes total sense. Since we bid a good share of our jobs, we
must come up with a material markup that includes profit. We don't have the
luxury of our customer paying for our cost of materials. Even so, I think the
overhead burden should partially be carried by the material. It takes time to
order the materials, space to store them (even short term), and often we're
financing the material on a short term (15-20 days) basis.

What do you do about non-productive hours for your cabinetmakers
(sweeping the floors, working on equipment, vacation, sick days, etc.)? I
looked one year at actual hours logged onto a job vs. available hours and
we spent about 15% of our time in the shop on non-job specific work. One
year, when we had a very strong growth spurt and spent a huge amount of
time adding equipment and space, we spent 23%! Now, that changes your
hourly rate! I take that into account when I'm figuring my rates. Do you?


Contributor B, I have kept track of employee hours worked and where. I find
that about 20% of total employee time is non-billable. That includes the
person™s time doing clean-up, tool and shop maintenance, as well as
production time. So I use a loaded labor rate that includes all costs, workers
comp, taxes that I pay, vacation and such (I used a year™s time and costs for
calculations). I then mark that up by dividing by .8 to get my average labor
cost per hour billable. I then mark up labor and materials to cover overhead
and profit. I divide by .6, so 40% of the selling price is to cover overhead
and profit. The big question is can I cover my overhead expenses at 25% of
my gross sales, leaving 15% for profit.


From contributor U:
In response to the original question, I think we need to look at this from
another perspective. The only reason you would hire additional employees
is in anticipation or confirmation of additional sales. In other words,
additional labor and general expenses do not determine your overhead, but
rather overhead determines your labor resources (quantity of employees
and rates for employees). More sales require and support it as a
percentage of sales.

You cannot let your overhead costs determine your product cost. If you did,
your costs would vary from month to month, and so would your prices to
keep consistent margins. Builders who build identical homes would not
accept differing prices for identical homes. You can, however, determine
your target sales level, and then determine your cost of sales and overhead
percentage of that sales level. From there, it is a simple matter of making
sure you hit or exceed your target sales level, and manage your cost of
sales and overhead percentages, making sure they fall within the target
ranges. This method answers the questions “Should I hire this employee,
and at what rate?” and “Should I purchase this machine, and at what cost?”
and many other questions like these.

Net profit is always calculated by taking total sales (throughput) and
subtracting cost of sales and expenses, then dividing the sum of these
expense categories into total sales. While the means may vary from
company to company, since some will include direct labor in cost of sales,
and indirect labor in expenses, and yet others will place both direct and
indirect labor as an expense, the net profit calculation is still the same, and



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Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


for net profit to be consistent, you must manage your sales, and your costs
based on the actual sales. Cost of sales kind of manages itself - when sales
goes up, cost of sales goes up, when sales drop off, cost of sales drops off.
Overhead, on the other hand, only follows this pattern if you manage it well,
which you must do.

In conclusion, you must drive overhead to your target level, not let it seek its
own level. It™s called management, and it™s not what most craftsmen desire
to do or are good at. We cannot base our overhead on hours worked.
Instead, we must base our overhead on anticipated sales, and manage
sales to that level or more, and manage overhead to stay within the target
percentage of sales.


From contributor A:
Contributor B, our nonproductive hours are rather minimal. Realize that we
are a three-man shop, so I come in on a Saturday morning and clean the
shop. Since my shop isn't as large as you guys with 20 employees, it only
takes me an hour or so at the most. I figure that this Saturday work more
than covers the days I take off to sail or golf. Too bad I can't put that in my
charge rate.


From contributor L:
I'd like to weigh in here. My overriding rule is that the customer pays for
everything. There is no such thing as work hours that are not billable. Any
charge that cannot be easily billed to a client has to have an accurate
representation as an overhead expense.

I break out my overhead charge into four categories. Fixed overhead for
machinery payments, building lease, utilities, taxes, retirement, etc - costs
that will be incurred no matter what. Variable overhead for machinery repair,
software expense, vehicle upkeep, etc - costs that are incurred on an
irregular basis. Salary overhead for the draws against owner's equity (I am
a sole proprietorship). And lastly, wage overhead for any employees.

I have tracked these different types of costs long enough to average out a
rate per hour for each of the categories. When bidding, each estimate
includes the raw material cost, the first three categories of overhead, and
last the wage overhead (only if I expect to use employees). All costs for
labor are applied against the expected labor for the project. No substitute for
experience on that one. This creates a subtotal which I then mark up by my
profit margin.

My feeling is that overhead is a quantifiable measurement with no
relationship to sales, except as an after-the-fact assessment. I know exactly
what my overhead cost is. I have no way of knowing what my future sales
are. If overhead is a percentage of sales, your overhead goes down when
your sales go down. That would hold true somewhat for wage overhead and
a portion of the variable overhead, but the salary overhead and the fixed
overhead remain unchanged. In conclusion, my salary and wage overheads
are a $/hour based on historical labor times for my service items. My fixed
and variable overheads are a $/hour based on historical times for project
completion. What this has allowed (forced) me to do is to tightly focus my
overhead dollars on labor saving expenditures (mostly machinery upgrades)
and bring in the wage overhead lastly. My business plan is to have all the
machinery in place and paid off so that then I have the flexibility to either
hire employees and work the production capacity side, or slow down and
take time off because my excess capacity allows me greater throughput. I
would appreciate any criticism.


From contributor B:
Contributor U, it seems your method gives the same result. If you do not
meet your sales quota, then is your overhead met? If not, then you must be
charging more for the same product on slow months.



4 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...



Are you saying your throughput is exactly the same every month? Whatever
formula, an owner must manage overhead, profit AND sales, not just one. In
a business that is typically a roller coaster ride of sales volume, I would
agree that managing sales is VERY important. But don't be charmed into
thinking (at least in custom work) that sales can be managed to a constant
level EVERY month.

Every shop must determine a labor rate, and that rate needs to be
determined by both historical and current data. The original question
concerned how to determine overhead for each employee. That is just as
important as managing sales. If you don't know what your overhead is, what
do you base sales on?

Most estimating is done by determining labor costs and material costs, then
adding the appropriate margins (overhead and profits). If you waited to see
what sales would be in the month that job is produced, you would never be
able to price a job.


From contributor U:
Contributor L, you stated: “My feeling is that overhead is a quantifiable
measurement with no relationship to sales except as an after-the-fact
assessment. I know exactly what my overhead cost is. I have no way of
knowing what my future sales are. If overhead is a percentage of sales, that
would mean your overhead goes down when your sales go down.”

If I understand your reasoning, if your overhead is $6000 per month, and
you do four jobs this month “ each with a customer cost before overhead of
$10,000, to which you add $1500 each as overhead - then what happens
next month if you only do three jobs, each with a customer cost before
overhead of $10,000? Do you add $2000 to each as overhead? What if you
were only to do one job all year - does that client bear the burden of your
entire overhead for the year? I know that is an exaggeration, but it seems
that by having a fixed overhead dollar figure, that it would have to happen
that way. It just seems to me that either your overhead fluctuates with sales
(which forces one to focus on sales, which is an infinite number, and
ultimately increases net profit since it is also a percentage of sales), or it is a
fixed amount that on bad months is not covered, and can never be
recovered (which forces one to focus on expenses, which are finite
numbers that can only be reduced so much, and can never be zero).

I suppose I don™t understand how it is that you apply this fixed overhead
number to a job. Is it applied based on the time it will take to manufacture?
Is it based on the number of jobs you will do in a given month? If so, is there
no relationship between the total sales for the month and the overhead
applied?

If you apply overhead based on your labor (which seems to be what you are
saying), then when you have a bad (low) sales month, you do not recover
all of your fixed overhead. The same holds true of an overhead based on a
percentage of the sale, but in the percentage of the sale method, you
recapture some of this on your good (high) sales months. Many times you
actually recover much more than you lost on your bad or low sales months.

Maybe if you answer this question, I will better understand how you™re
applying your overhead. Would two identical jobs always cost your
customer the same amount, even if they were done 3 or 4 months apart?

Contributor B, you stated: “It seems your method gives the same result. If
you do not meet your sales quota, then is your overhead met? If not, then
you must be charging more for the same product on slow months.”

It depends on how the overhead is applied at the estimate stage in his
method. If it is based on man-hours, then yes, it should work very much the
same as a percentage of sales, because it actually becomes a percentage
of labor, which if the man-hours are predicted correctly each time, then



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Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


identical jobs will cost the customer the same amount. If, however, he
calculates his material and labor, then applies a flat overhead fee to each
job based on how many jobs will be run that month, the cost to the customer
will vary depending on the workload for the month. The danger in the
overhead being applied based on labor is some jobs have very little labor,
and very expensive materials. You simply get a more consistent result by
applying overhead based on both material and labor rather than one or the
other.

You asked: “Are you saying your throughput is exactly the same every
month?”

No, my sales level is not the same every month, but there are a lot less
months that dip below my target sales level since I began to understand that
the most devastating thing I could do to net profit was to not sell enough to
cover my costs (better said, not know my break-even point, and stay above
that point). Typically my sales are much higher than the level my overhead
was based on, which means that the overhead converts to additional profit.
One of the reasons that my sales are higher than my target level is because
I have learned to focus on sales (infinite, can be anything I desire) rather
than costs (finite, can only be reduced so much), and since net profit is a
percentage of sales, the higher the sales, the higher the net profit if
overhead and cost of sales moves proportionately.

You also stated: “Whatever formula, an owner must "manage" overhead,
profit AND sales, not just one. In a business that is typically a roller coaster
ride of sales volume, I would agree that managing sales is VERY important.
But don't be charmed into thinking (at least in custom work), that sales can
be managed to a constant level EVERY month.

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