CWB April 2001

Destination: Profitability

Advice for assembling salary requirements, indirect labor and overhead costs to arrive at an effective hourly shop rate. The third in a series.

By Anthony Noel

Did you get your homework done? As a high school student I dreaded that question, particularly when it came to math homework because all too often, the answer was "no." I hated math. Utterly despised it. Some of my fear and loathing of things numeric could be directly traced to my experiences as one of the many unfortunate elementary school guinea pigs victimized by a late-60s teaching experiment known as "The New Math." But a lot more of it was due the overriding belief, shared by so many of my fellow math haters, that I was never gonna use this stuff in "real life."

Imagine my surprise at learning years later that math, applied to real-life situations, is anything but useless, let alone intimidating or boring. As I mentioned earlier in this series, math is a tool, the same as any other tool in your shop. And the better you get at using it, the better your results will be.

If it seems more than a little ironic that a former math hater like me has been assigning readers like you what is essentially math homework for the last couple of months, rest assured: That irony is not lost on me.

But life has taught me that the success of any business is directly proportional to how much attention the business pays to the numbers on which profitability turns. And I firmly believe that if you carefully and accurately complete the assignments I've given you, you will gain insights that will help you reach your destination: profitability.

So: Did you get your homework done?

Your assignment last month was to keep track of direct and indirect labor. In addition, you were to continue tracking time spent on specific tasks within specific jobs.

If you have kept up with these assignments, you now have a pretty good idea about how much of your average day is spent in tasks directly related to given jobs in the shop, and how much time you spend on things that can't be "billed" to any one customer. Our goal in discovering this particular ratio is to determine an indirect labor number that we can equitably recoup from all of our customers over the course of a year.

Let's say, for example, that you work a grand total of 55 hours per week. You have kept track of your time and discovered that on average, 37 of those hours are spent working directly on projects for specific customers, and the remaining 18 are consumed in estimating, sales calls, general bookkeeping, employee and/or vendor management and similar indirect pursuits.

Let's say you want to make a salary of $50,000 per year. You first need to estimate, as accurately as possible, how much of it will come from direct labor, which is time in the shop, working on specific jobs. Once you are comfortable that 37 hours (or whatever you come up with) is a good average for the number of hours you work on particular jobs (remembering that some weeks it will be more and some it will be less), you are ready to (gasp!) do some math:

If you contribute 37 hours per week of direct labor for 50 weeks, that's a total of 1,850 hours per year. (Those two missing weeks are your vacation. I'm not completely heartless!)

The 18 hours you apply to indirect tasks, times 50 weeks (allowing again for vacation), comes out to 900 more hours. Add these hourly totals together, and you get 2,750 hours worked for the year. When you divide $50,000 by 2,750 hours, you get an hourly rate of $18.18. Multiply that rate by 900, and you see that $16,362 of your salary (the indirect part) must be garnered through overhead. The remaining $33,633 comes from direct labor; it assumes that you will average 37 hours per week on specific jobs during a given year, making $18.18 for each of those hours.

So how do you "make up" that $16,000-plus difference in indirect labor?

By applying it to your overhead costs.

For simplicity's sake, we have been using the one-man-shop model throughout this series. We will carry that through here, but bear in mind that the same rules apply, regardless of your business's size: You have to study average time spent in direct and indirect labor, then apply what you learn, if you want to develop a shop rate based on the realities of your shop's productivity.

So let's forget everything else for a moment and focus on getting you your $50k per year. You work 37 hours per week on specific jobs, and you charge $18.18 for each of those 1,850 hours. This earns you $33,633. To "make up" that other $16,362 of indirect labor, you need, as we've been saying, to distribute it equitably across all the actual jobs you produce during the year.

To do this, divide that $16k figure by the total time you project spending on direct labor (1,850), then add the result to your hourly rate. In this example, you would add $8.85 to your rate of $18.18, for an effective hourly rate of $27.03. Multiply that by your total direct hours (1,850), and you get your annual "nut" of $50,005.50.

But there's a catch. Remember how I said, "Let's forget everything else for a moment"? Your moment is up.

What we have just demonstrated is how to distribute one - and only one - overhead expense across the year's work. But you have many overhead costs. So your homework assignment for the next month is twofold: (1) play around with the your own numbers in the formula we have just covered, to get a feel for it. Then (2), document all of your indirect costs (a.k.a. overhead) for the past year. Checkbook registers and invoices are great sources for this information. Get a total that we can add next month to your indirect labor cost.

Remember, we are not talking about invoices for material dedicated to specific jobs; that's a direct expense. We are looking for phone company bills, utility bills, costs for equipment maintenance, tool sharpening, trash removal, rent, loan payments, vehicle expenses, professional fees, i.e., everything that you need to do business, but that you can't reasonably charge to a particular job.

Be thorough; take no shortcuts. And we'll see you back here next month.


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