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How overhead affects your margins and improves decision making

Aug 30, 2021

Many manufacturers struggle to gain a complete picture of what it really costs to engineer, manufacture and deliver products to their customers. They have great visibility into how much raw material they’re consuming and labor hours they’re scheduling, but when it comes to calculating overhead and using it to make business decisions, there’s a disconnect.

It’s certainly no easy task to identify all the variable and fixed overhead costs associated with manufacturing. But it’s worth it. You might be asked by customers to cut costs. You might need to account for the impact of changes in technology and automation, the labor market and sourcing materials on the costs of products produced. Whatever the case, determining how overhead affects your margins can lead to improved decision making.

How to calculate overhead and its impact on margins

Job cost accounting is what you need to identify your true production costs and align them with your pricing and profitability. These four components can get you to your true costs: expense groups, allocation drivers, work centers and finished outputs.

1. Expense groups

We’ve seen all types of charts of accounts and P&L designs. Some are much easier to understand than others, so we recommend looking at the design first. Review all your indirect manufacturing expenses and rearrange them by like quantities everyone can understand, such as operations, finance and executive.

2. Allocation drivers

Next, highlight what direct activities created or drove the newly grouped expenses. Look at simple designations, such as machine hours, labor hours, square feet and actual expense.

For example, if you’re running a job shop and use lasers, look at your utility expense. Machine hours are often the most relevant driver of that expense. Or if you provide employees with uniforms, that expense can be grouped with labor hours. Rent, cleaning and lawn maintenance can be attributable to square footage.

Depreciation is also important. You might have a mix of dependable but old machinery that are no longer driving depreciation expenses, but they’re sitting alongside much newer pieces of equipment that are. If you spread your overhead evenly, you can’t understand how each machine truly drives margin. Same thing with maintenance. If you tie maintenance expenses back to individual machines, you might learn that processes you thought were profitable aren’t because it’s taking too much money to keep those machines in working order.

3. Work centers

Your third step is to detail the operational work centers so you can apply the grouped expenses. Decide what level of granularity you want to calculate against the work centers. The key here is to make sure it’s an area where you can measure hourly activity and outputs, such as:

  • Lasers
  • Water jets
  • Production lines
  • Fabrication department
  • Locations

Sometimes you don’t have the data to get to how many hours a machine was running or how many hours one person was in a work center. But if you’re able to work through one level, like a production line, you can take the exercise and, as you accumulate more data, drive to more granular detail and see what machine is driving what specific cost.

4. Finished outputs

Finally, tie the individual operational machine and labor data to overall organization statistics, apply the work center percentages to the grouped expenses, normalize by labor or machine hour, and summarize.

For example, you determine you used 11,000 laser machine hours last year, and your total machine hours were 38,500. Therefore, the laser work center consumed 29% of all machine hours in your facility.

Let’s say you’ve tied your gas/vehicles expense to machinery because you sell machine hours, which means 29% of the gas/vehicle expense is allocated to the laser work center. You spent $142,900 last year on gas/vehicles. To apply the work center percentage to the grouped expenses, you multiply 0.29 by 142,900 and get 41,441. This means $41,441 of your vehicle/gas expenses are attributable to the laser work center.

If you want to normalize by labor hour, divide 41,441 by the number labor hours attributable to the laser work center. For this example, we’ll say it’s 10,400 hours. This means you spent $3.98 on gas/vehicles per labor hour.

True costs and how they impact margin

Once you’ve done the math, you can start digging into what it tells you and where you can get more ROI. Should you invest in a nesting program to cut down on labor hours? Can you then sell excess laser capacity?

One manufacturer we worked with was only running one shift, so they sold excess laser capacity on a second and third shift. Because they spread their overhead equally, they didn’t understand exactly how profitable doing this was for them, but once they did this exercise, they learned not only how profitable it was but also how to get even more margin dollars coming out of it.

Another example is a food manufacturer. They were doing high-volume, low-margin private label work on older machines. They found increased volume and margins for a gourmet version of a food product, so they invested in new machinery to manufacture it. Because they spread depreciation dollars across all production lines, their perceptions were skewed when they wanted to make a decision whether to divest the private label lines and go all-in on the gourmet line. In reality, the margin on the private label side was higher because there was no depreciation on the production line — all depreciation was tied up on the gourmet line. As a result, they started doing an optimal product mix calculation to determine how they should set up and run their business.

How to improve margins: Job costing

Now that you know how your overhead impacts your margins and what types of decisions you can make through job costing, it’s time to get started. And that’s where Wipfli can help. Our job costing specialists can take you through a two-day operational workshop to break down the components of your manufacturing activities and identify the drivers of your overhead. Then we provide you with a list of recommendations for improvements.

Click here to learn more about how Wipfli can help you align product costs, pricing and profitability.

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Brett Polglaze
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