How to Calculate Overhead-Cost-Per-Hour By Department
Originally published: 06.01.11 by Ruth King
Using this measure will provide a more accurate picture of profitability than when using gross margin alone.
Editor’s note: This is the second in a two-part series on how to more accurately measure the profitability of jobs by calculating and using overhead-cost-per-hour instead of gross margins. The first article ran in the May 2001 issue of HVACR Business and can be accessed via the issue archives at www.hvacrbusiness.com.
This departmentalization method is the fairest way I know to allocate overhead to different departments. I have consistently used this methodology for the past 18 years with hundreds of contractors. It works.
There are two causes of overhead: people and space. Let’s take a deeper look at both.
Space: Five expenses alone comprise space-related overhead cost: rent, utilities, building maintenance, building taxes, and building insurance.
Determine the total amount of productive space used by each department. Productive space is the space occupied by people or other assets related to a revenue-producing department. Common areas or areas used by overhead personnel are not counted in this equation. For example, your bookkeeping space doesn’t count; your reception space doesn’t count. The space that is used by the finance department or other people who are not directly bringing in revenues does not count in this equation. The only spaces that count are those related to service, new construction, replacement, or whatever departments you have.
For example, if you have a 5,000-square-foot-building, and of that 5,000 square feet:
• 1,000 is being used by service and replacement employees/other assets; and,
• 3,000 is being used by new-construction employees/assets;
• there is a total of 4,000 productive square feet.
• 25% of the space overhead costs are assigned to the service and replacement department (1,000/4,000);
• 75% of the space related overhead costs are assigned to new construction (3,000/4,000).
If total company rent is $1,000 per month, then the service and replacement departments’ share of the rent is $250; and the new construction department’s is $750 each month.
People: Every overhead item not listed under space is related to people. For example, more employees mean more office supplies. More people mean more telephone expenses.
If you know the exact percentage of time that somebody spends in a particular department, then take that percentage rather than the overall estimate in this calculation. For example, if you know that your service bookkeeper spends 100% of her time in the service department, then obviously the service department will get 100% of her salary. If your bookkeeper splits her time among service, new construction, and electrical, you may need to determine how much time she is spending in each one of these departments on their tasks, and then allocate her salary appropriately.
If supplies are bought for only one department, then that department gets 100% of that expense. For example: service tickets. The new construction department is not going to use service tickets, so the service department will pay for the service tickets. Another example is phone-directory advertising. It’s very unlikely that the new construction department would use this. It is a service-and-replacement-expense. Split the cost 50/50 between those two departments.
For other overhead items that are split, determine the total amount of productive payroll, i.e., revenue-producing, field-personnel payroll. Then, if the total productive payroll is $100,000, and the service productive payroll is $50,000, new construction’s productive payroll is $20,000 and replacement is $30,000, the service department’s share is 50% (50,000/100,000), new construction’s share is 20% (20,000/100,000), and replacement’s share is 30% (30,000/100,000).
Once you know the total amount of overhead for each department, then it is time to calculate the cost-per-hour.
Remember to use only productive payroll — or the number of revenue-generating hours — for each department. These are the hours that you can bill for. Your company has to cover all of its costs through billable hours. Training hours don’t count. Travel hours don’t count, unless you bill them to the customer. Running to the supply house hours don’t count, unless you can bill them to the customer.
The overhead-cost-per-hour is the total overhead cost divided by the total number of productive hours in that department.
Getting Started on Overhead-Cost-Per-Hour Calculations
(Editor's Note: To download the spreadsheet that correlates to this section, go to www.hvacrbusiness.com/downloadcenter.)
First, take your company’s year-end payroll, which lists the total payroll and payroll hours for each employee. Separate the employees into the different departments. Total the payroll for each department. Remember that you are only interested in productive payroll. If you have sales people, include their salaries in the department they sell for. Also, if some of the field employees work in two departments, estimate the amount of time that a tech spends in each of the departments and allocate his payroll accordingly. For example, assume a service technician worked 2,000 hours and earned $50,000 last year. He spent 20% of his time in replacement, and 80% of his time in service. Then 1,600 hours and $40,000 would go in service department labor, and 400 hours and $10,000 would go into replacement labor.
Once all of the departments’ productive payroll and payroll hours are calculated, then add all the departments together to determine the total productive payroll and payroll hours. Each department gets a percentage based on its payroll divided by the total payroll.
Estimate the space requirements for each department. Each department receives its percentage based on the total productive space.
Then, get your latest fiscal year end’s financial statements showing the total overhead for the year. Using the spreadsheet titled “Overhead Cost per Hour” enter the totals of each overhead expense in the yellow areas. Remember to include the proper percentages for space and for labor overhead expenses.
Here’s what to watch out for when you complete the spreadsheet:
1. Put the amount of square footage that each department occupies in the yellow boxes.
2. Put the numbers from your year-end W-2s in the yellow boxes. The top box is for dollar figures. Remember to use only productive payroll. The lower box is for the total hours for each department.
3. Use your last fiscal year-end profit-and-loss statement to enter the numbers in the yellow boxes under overhead expenses. In some cases, you might know exact numbers and do not need to rely on percentages. If you know exact numbers, put those numbers under each department. For example, if you, as the owner, know that you spend 90% of your time in the replacement department, 10% of your time in service, and 0% of your time in maintenance agreements, then enter 90% of your salary in the replacement box under salaries — officers; 10% in the service box under salaries — officers; and 0 in the maintenance agreement box under salaries — officers.
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