Putting Cost Back into Pricing:
Calculating Overhead Percentages
by Alan Hauff
Competitive
pricing is always an important concern. This article outlines
how to calculate overhead percentages and how to use them to determine
product
pricing.
Competitive pricing is always a hot button with business owners. They
know competitive prices will attract customers. They also know that
price is usually one of the first pieces of information buyers collect.
If they can make a favorable first impression, they feel increased sales
and loyal customers will follow.
The downside of competitive pricing is that many business owners establish
prices without analyzing their costs. They simply use their competitor's
price as a benchmark and make the assumption that it will cover costs
and provide a margin for profit. Unfortunately, this assumption is seldom
correct, especially if they choose to price themselves below the competition,
which is quite common. Everybody's costs and profit margins are different
and what may be acceptable for one business may result in a loss for
another. Often, business owners will say, "I'll raise my prices later,
after I have customers," or "I'll make up for lower prices with volume."
Most of the time, this does not work because of market factors.
Business owners need to have a good understanding of their business
expenses and how these expenses impact the overall pricing structure
of their business. Most owners understand the cost of individual items
but many lack a methodology that insures all these costs are captured
in their selling price. They encounter difficulty when they try to factor
overhead items such as indirect labor, interest, rent and utilities
into their price. These costs are not easily attributable to a particular
product or service and often one or more is overlooked.
A preferred method of capturing costs is to calculate an overhead percentage.
The overhead percentage provides an easy way to factor overhead expenses
into a selling price and a convenient way to monitor the impact changing
costs has on prices. It provides the business owner with a means to
allocate overhead expenses proportionately to the direct labor dollars
billed to each customer. Although the overhead percentage formula is
simple to use (divide the overhead expenses by direct labor), it requires
an understanding of pricing terminology and a working knowledge of the
process for calculating it.
Pricing Terminology
In order to calculate an overhead percentage, business owners should
become familiar with the terminology used in the overhead percentage
formula. The terms differentiate between billable (income producing)
and non-billable (non-income producing) activities and assist in categorizing
costs used to estimate the percentage. The important terms to remember
are
Business expenses: all expenses found on the
company's income statement (also known as the profit and loss statement).
Overhead expenses: all costs found on the income
statement except for direct labor, direct materials, and costs
attributable to outside subcontractors that can be billed directly
to a customer's account.
Overhead expenses are absorbed by the business and factored into the
selling price as a percentage of the direct labor cost. They include
indirect costs such as accounting, advertising, depreciation, indirect
labor, insurance, interest, legal fees, rent, repairs, supplies, taxes,
telephone, travel and utilities.
Direct labor: labor used to produce products and services
purchased by customers. These man-hours are directly attributable
to customer activity.
Indirect labor: labor used to provide supporting services
to the business such as accounting, clerical, custodial, customer
services, management, purchasing, sales, and warehousing. These man-hours
support business functions but are not directly chargeable
to the customer.
Direct materials: materials used in the final product
or service purchased by customers. These materials are charged directly
to the customer's account.
Overhead percentage: ratio between direct labor and
overhead expenses. This percentage is used to allocate overhead expenses
proportionately to direct labor dollars billed to customers.
Calculating the Overhead Percentage
The overhead percentage is calculated using a seven-step process.
The steps are listed below:
Step 1: Determine the "average" hourly wage paid to
direct labor employees.
Classify each employee's contribution, or portion thereof, as either
direct or indirect labor. Determine the hourly wage rate paid to each
direct labor employee and include the business owner if applicable.
Total the hourly wage rates and divide by the number of employees
counted.
Step 2: Estimate direct labor workdays available in
the calendar year.
Calculate the number of direct labor workdays in a calendar year by
subtracting the average number of days that direct labor employees
will not be present for work because of weekends, holidays, vacations
and miscellaneous (e.g. injury, personal, sickness, etc.). Count only
direct labor employees. Do not include any indirect labor employees
in this estimate.
Step 3: Estimate billable direct labor hours
for the work year.
Multiply available direct labor workdays by the scheduled 8-hour workday,
minus the average number of daily non-billable direct labor hours.
Non-billable direct labor hours include lunches, breaks, company meetings,
training, cleanup, etc. that a customer will not pay for directly.
Step 4: Estimate billable direct labor dollars for
the work year.
Multiply billable direct labor hours by average direct labor wage.
Step 5: Estimate non-billable direct labor dollars
for the work year.
Subtract billable hours from the total man-hours available in a work
year, which is 2088 hours. The remainder equals the non-billable direct
labor hours. Multiply this number by the average direct labor rate
to arrive at the non-billable direct labor dollars. These costs are
absorbed by the company and must be passed on to the customer in the
overhead percentage.
Step 6: Estimate all overhead expenses for work year
to include non-billable direct labor.
Refer to actual or pro forma income statement and total all the business
expenses shown for the year. Deduct the cost of billable direct labor,
direct materials, and costs attributable to outside subcontractors
that can be billed directly to a customer's account. Do not deduct
the cost of non-billable direct labor. Adjust the overhead expenses
for yearly inflation and projected price changes by multiplying the
total by the anticipated percentage increase.
Step 7: Calculate the annual overhead percentage.
Divide the yearly overhead expenses (step 6) by the yearly billable
direct labor dollars (Step 4), and convert this ratio to a percentage.
Using the Overhead Percentage
Calculating a selling price is a simple process once the overhead percentage
has been determined. However, most business owners are not prepared
for the results they see. Their reaction is usually one of surprise
and disbelief when they realize the impact this percentage has on their
selling price. They are often heard to say, "I couldn't charge those
prices if I wanted too!" This may be true, especially if their customers
are price sensitive, but the alternative may mean a business failure.
Success and profitability demand that costs be factored into the selling
price. The overhead percentage gives the business owner an opportunity
to analyze business expenses and determine whether or not noncompetitive
pricing strategies should be the main competitive focus.
After computing the overhead percentage, each of the assumptions made
in projecting direct labor and overhead expenses should be revisited.
This will allow changes to be made and will help formalize the process
of calculating an overhead percentage. Business owners are always very
curious about this process and find the information extremely helpful.
As each step is calculated, they begin to visualize the larger pricing
picture and actually see the impact that everyday business decisions
have on their selling prices.
Authored by: Alan Hauff, Small Business Program
Specialist, University of Missouri Extension, University of Missouri-St.
Louis
Copyright ©: Curators of the University of Missouri
