How Overhead Impacts Profitability

by WOHe

The typical kitchen and bath remodeling business
cycle consists of a series of jobs that we do for clients. The
usual practice is to analyze the job, figure a price based on what
we perceive our profit needs to be, and then perform the job and
collect the contract amount.

There are two parts to this process of job pricing:
estimating our costs, and determining how much to mark up those
costs to arrive at a selling price. While there are obviously
market constraints that impact how much cost can be marked up in
selling a project, there are some real constraints on the amount of
gross profit that must be generated to cover overhead.

This month, we’ll look at the elements of overhead,
their relationship to the volume of our business and how to
determine a markup that will cover overhead costs.

What is overhead?
The costs that a kitchen and bath firm incurs in the production of
its products or services are broken down into two general
categories: direct cost of sales and overhead. The easiest way to
make the distinction between the two is that direct costs would not
be incurred if we were not doing a particular job, while overhead
cost would continue regardless of whether or not that particular
job is being produced.

Since overhead is not directly driven by the level
of our production volume, it’s an area where business judgment
plays a major role. Within the overhead category, there are
elements that are somewhat fixed costs, and there are other costs
that are variable. Fixed overhead costs include such items as rent,
utilities, fixed asset costs, and the like. The variable elements
are costs such as payroll, commissions, office supplies, and
similar emphasis.’

As you can probably see, the relationship between
fixed and variable overhead expenses is more of a continuum, with
each type having a more or less variable character. It’s only in
the short run that such expenses are truly fixed.

The nature of overhead costs tells us that it’s
important to attempt to look ahead at our business to try to access
sales volumes as accurately and as far into the future as possible.
One of the realities of all costs, but overhead in particular, is
that it’s much easier to add to them than to reduce them. It should
also be apparent that adding overhead of the relatively fixed
variety, such as increased office space, is the most difficult to
later adjust.

In theory, the most easily adjustable type of
overhead should be payroll, since employees can be added or let go
with reasonably short notice. In practice, however, there are
several reasons that reducing employee levels is quite difficult.
The most obvious reason is the human impact of layoffs and the
associated implications for the company’s morale.

A more subtle result of adding employees to your
organization is the reorganization of the work load among
employees. Once the tasks performed by one employee have been
divided and some of them assigned to a second employee, it will be
extremely difficult to reconsolidate this work load. The lesson
here is that we need to make sure that employees are not added
until we can determine that the need is significant and
permanent.

Most overhead expenses are somewhat like employee
levels in that it’s easy to add things that become necessities that
will later be difficult, or even impossible, to cut back on. In
this category are various employee benefits and perks.
One of the most difficult types of overhead expense to judge is
that of marketing and advertising. Since this is a cost designed to
boost revenues, it’s not one that you can, or should, adjust
downward when business falls off. Here, again, the key is to make
sure that you carefully evaluate the effectiveness of these
expenditures.

Covering overhead
In evaluating the overhead levels of your business, it’s important
to be able to determine the point at which your production will
produce enough gross profit to cover all of your overhead and
produce a net profit for the business as a whole. This point is
known as a “break-even” point.

Gross profit is defined as the difference between
the direct cost of production and the sell price of that same
production. If the amount of the gross profit is divided by the
sale amount, it produces a gross profit percentage that is
extremely useful in evaluating many business decisions.

The break-even point for your business can be
determined by dividing the total overhead by the gross profit
percentage (expressed as a decimal fraction). As an example:

Total overhead expense: $50,000
Gross profit percentage: 35%
Break-even point = 50,000/.35 = $142,857

In other words, $142,857 of revenue is needed to cover overhead
expenses if gross profit on those sales is 35%.
Another useful exercise for this break-even formula is to evaluate
the cost of additional overhead. Using the same formula as above,
it’s possible to determine that adding payroll and benefits for an
additional employee costing $4,000/month will require additional
revenue of $11,428 of sales to cover this cost.

Another use of this gross profit analysis is to
evaluate the impact of changes in pricing strategies on the
break-even point. Again, using the example above, if we increase
our gross profit percentage by 1%, we see that our break-even point
is reduced by nearly $4,000, to $138,889. Conversely, the effect of
cutting prices to “get the job” can be seen by again using the same
formula. If we were to cut the price on our jobs by 5% (a minimum
amount of price reduction that would probably have an impact on a
customer’s decision to buy), we would have to increase revenues in
our example above by nearly $24,000, up to $166,667, to cover the
same $50,000 overhead.

Understanding the relationship between cost, gross
profit, overhead and break even is critical for all of us as we
attempt to make decisions about adding staff, increasing benefits
or adjusting prices. As you can see from the examples, break-even
analysis is not difficult to do, and you can even do a lot of this
in your head as you evaluate decisions on a daily basis. Every time
a decision is necessary with regard to increasing or decreasing
expenses, estimate the impact on your break-even point before
moving forward with it.

Next Column: When the Client Won’t Pay.

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