Are you charging the right price?

Calculating the overhead percentage for your business is critical to pricing your goods and services profitably and operating your business successfully.

Competitive pricing is always a hot-button issue with business owners. They know competitive prices will attract customers and that price is often the first piece of information buyers collect. So they rationalize that if they can make a favorable first impression on price, increased sales and loyal customers will follow. What they fail to realize is that price-conscious consumers are not always loyal customers. They often choose the lowest price over anything else the business owner can offer.

Many business owners establish prices without understanding or analyzing their own costs of doing business. They use their lowest competitor’s price as a benchmark and make the assumption that they can sell their good or service at or below this price. They justify this by saying, “I’m as good as my competition or better.” What they do not understand is that costs and profit margins are different for every business. What works well for one competitor may actually yield a loss for another. Still, business owners will justify their pricing decision by saying, “I’ll raise my price later, after I have customers,” or “I’ll make up for my lower price with increased volume.” All too often though, this does not happen. Price-sensitive customers resist price increases by shopping elsewhere, and competitors fight back with lower prices, leaving business owners that follow this strategy in a no-win situation.

To compete effectively, business owners need to have a basic understanding of their costs and a procedure for capturing these costs in their selling price. Although most owners can relate to individual costs because they see an invoice or write a check, many lack a systematic approach for capturing their combined costs in the selling price of a good or service. Their biggest challenge occurs when they try to factor in overhead expenses. Many of these costs are not easily attributable to a particular product or service (i.e. indirect labor, insurance, rent, utilities, etc.) and they often get assigned disproportionately or are overlooked entirely when pricing a good or service.

Pricing starts with a formal review of all business expenses, which includes separating these expenses into three categories: direct labor, direct materials and overhead costs. These costs are considered either billable or non-billable activities. Overhead costs are non-billable activities and are factored into a selling price as a percentage of the direct labor cost, which is a billable activity. During the review process, the business owner will become acutely aware of the costs associated with doing business and begin looking at different ways to manage them.

Calculating overhead percentage is the most effective way to capture overhead costs in the selling price. This percentage provides a means to allocate these expenses proportionately to the direct labor dollars billed to each customer. It is calculated in a seven-step procedure that separates employee time into direct and indirect labor, identifies available workdays and billable direct labor hours and isolates overhead expenses. To calculate an overhead percentage, business owners must become familiar with the terminology used in the seven-step procedure and be able to differentiate between billable (income producing) and non-billable (non-income producing) activities.

Pricing terminology

Here are some important terms to remember.

  • Business expenses: All expenses found on the profit and loss statement.
  • Overhead expenses: All costs found on the profit and loss statement except for direct labor, direct materials and costs attributable to outside subcontractors. (Note: If it can be billed directly to a customer’s account it should not be considered an overhead expense.). 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 goods and services purchased by customers. These man-hours are directly attributable to customer activity (billable).
  • 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 (non-billable).
  • Direct materials: Materials used in the final product or service. These materials are charged directly to the customer’s account (billable).
  • 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 overhead percentage

The overhead percentage is calculated using the following seven-step procedure.

Step 1: Determine average hourly wage paid to direct labor employees

Classify each employee’s work contribution or portion thereof as either direct or indirect labor. Determine the hourly wage rate paid to each direct labor employee including 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 other factors such as injury, personal days, sickness, etc. Count only direct labor employees.

Step 3: Estimate billable direct labor hours for work year

Multiply available direct labor workdays by the scheduled eight-hour workday minus the average number of daily non-billable direct labor hours. Non-billable direct labor hours include company-paid lunches, breaks, meetings, training classes, cleanup, etc. that a customer is not expected to pay for directly.

Step 4: Estimate billable direct labor dollars for work year

Multiply billable direct labor hours by average direct labor wage.

Step 5: Estimate non-billable direct labor dollars for work year

Subtract billable hours from total man-hours available in a work year, 2,088 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 through the overhead percentage.

Step 6: Estimate all overhead expenses for work year to include non-billable direct labor

Refer to actual or proforma income statement, total all the business expenses shown. 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 total for inflation and projected price changes that will occur in labor and materials for the coming year.

Step 7: Calculate the annual overhead percentage

Divide overhead expense (Step 6) by the billable direct labor dollars (Step 4).

Using overhead percentage

After calculating overhead percentage and using it for the first time to determine their selling price, most business owners find that they should be charging a higher price. Even when they re-calculate the overhead percentage a second or third time, after making adjustments to lower their costs or increase their direct labor, they still may find it necessary to increase their price. This occurs because the bulk of their overhead costs will remain relatively constant and previously, they did not factor all of them into the selling price. In using the overhead percentage, business owners find it to be an invaluable tool. By using it, they get a deeper understanding of their business expenses and learn how to price their goods and services profitably.

Conclusion

Failure to take all business expenses into consideration when pricing goods and services is a key problem for many business owners. They often lack a methodology for doing this, and many times will choose to ignore or overlook some of their costs to price their goods and services competitively. Using the overhead percentage ensures they will take all of their business expenses into account and help highlight the impact their day-to-day management decisions have on selling prices. After using the overhead percentage, their reaction is often one of surprise and disbelief — “I couldn’t charge those prices if I wanted to!” Perhaps this is true, but when they know where their prices should be, they can begin taking corrective action to either increase prices or look at alternatives to decrease costs. Such action is necessary to operate their business profitably and successfully.

Practical exercises

These two exercises demonstrate how to calculate an overhead percentage and use it to compute a selling price using the terminology and steps above.

Exercise #1: Calculating the overhead percentage for a service business

Jones Painting Company is a small service business that provides painting and related services to commercial and residential customers. In addition to the owner, there are four direct labor employees. The employees are paid union scale, which is $20/hr, and the owner is paid $25/hr.

Normally, the company does not schedule weekend work. It recognizes 10 holidays each year. It also provides each employee and the owner with 10 paid vacation days. Employees and the owner average one unscheduled absence per month. In a typical eight-hour workday, employees average two hours in non-billable activities and the owner averages four hours.

The company has budgeted $400,000 for all business expenses found on its income statement for the current calendar year. This includes $80,000 for direct materials and $10,000 for subcontractors.

Required:

1. What is the average direct labor wage paid per hour?

  Employee 1 $ 20
  Employee 2 $ 20
  Employee 3 $ 20
  Employee 4 $ 20
  Owner      $ 25
             $105/5 employees = $21/hr

2. How many workdays are available to Jones Painting Company in the above scenario?

  Calendar days        =  365
  Less non-work days:
    Weekends             -104
    Holidays             - 10
    Vacation             - 10
    Personal             - 12
  Non-work days        = -136
    Workdays available =  229

3. What is the total number of direct labor man-hours projected to be billed during the work year for the owner and employees?

  Total workdays available     =   229
  Scheduled work hours             x 8
  Hours available per employee = 1,832
  Number of employees              x 5
  Total hours available        = 9,160
  Less non-billable time*       -2,748
  Billable direct labor hours  = 6,412

  *Note: Each employee averages two non-billable hours per day x 229 workdays. 
         Owner averages four non-billable hours per day x 229 workdays. 
         2 hrs x 229 workdays x 4 employees = 1,832 
         4 hrs x 229 workdays x 1 owner      +  916
         Non-billable direct labor hours    = 2,748

4. What is the dollar value of the billable direct labor?

    Billable direct labor hours             =    6,412
    Average direct labor wage                 x    $21/hr
    Estimated billable direct labor dollars = $134,652

5. What is the dollar value of the non-billable direct labor?

  Man-hours available per employee/work year  =  2,088 hrs (261 workdays x 8 hrs)
    Number of direct labor employees            x    5
    Total man-hours available                   10,440
    Less billable direct labor hours           - 6,412
    Non-billable direct labor hours              4,028
    Average direct labor wage per hour          x  $21/hr
    Non-billable direct labor dollars          $84,588

6. What is the projected overhead dollar expense for the work year?

  Business expenses          = $400,000
  Less:
  Direct labor               - $134,652
  Direct materials           - $ 80,000
  Subcontractors             - $ 10,000
  Projected overhead expense - $175,348

7. What is the annual overhead percentage for Jones Painting Company?

  Yearly overhead expense = Annual overhead rate
  Yearly direct labor cost
  $175,348 = 1.302 or 130%	
  $134,652

8. What should Jones Painting Company’s labor charging rate be if it wants a 15% gross margin on sales?

  Average direct labor rate   = $21/man-hr
  Overhead rate @ 130%        + $27.30/man-hr
  Direct labor cost           = $48.30/man-hr

  15% gross margin on selling price = $48.30/ .85 = $56.82 charging rate/man-hr

Exercise #2: Calculating the price of a product

Countryside Specialties is a small specialty food business that creates new recipes for bread, cake and drink products then packages the required dry ingredients for sale to specialty food and drink shops, gourmet coffee shops and large department stores. The owner is planning to introduce a new lemon poppy seed muffin mix and needs assistance pricing it.

The company has four direct labor employees including the owner. Two employees are paid $6/hr, one employee is paid $7/hr and the owner is paid $13/hr. Because of the seasonal nature of its business, the company averages 165 non-work days per year. On typical workdays, employees average six hours and the owner averages two hours in production-related activities. The company’s projected cash outlay for the coming 12 months will be $197,944. This includes $75,000 for direct materials, $35,600 for direct labor including the owner’s contribution, $21,944 in owner’s salary and $65,400 in other business expenses.

The owner has determined that one batch of muffin mix will require four man-hours of production time and will produce 120 units. Ingredients and packaging materials will cost $.73 per unit.

Required:

1. What is the average direct labor wage paid per hour?

  Employee 1 - $ 6
  Employee 2 - $ 6
  Employee 3 - $ 7
  Owner      - $13
               $32/4 employees = $8/hr

2. How many workdays are available to Countryside Specialties, assuming there are 365 days in this calendar year?

  Calendar days            = 365
  Less non-workdays        - 165
  Total workdays available = 200

3. What is the total number of direct labor man-hours projected to be billed during the work year for the owner and employees?

  Total workdays available     =   200
  Scheduled work hours         x     8
  Hours available per employee = 1,600
  Number of employees          x     4
  Total hours available        = 6,400
  Less non-billable time *     - 2,400
  Billable direct labor hours  = 4,000

  *Note: Each employee averages 2 non-billable hours per day x 200 workdays 
         Owner averages 6 non-billable hours per day x 200 workdays 
          2 hrs x 200 workdays x 3 employees = 1,200 hours 
          6 hrs x 200 workdays x 1 owner     = 1,200 hours
          Non-billable direct labor hours    = 2,400 hours

4. What is the projected overhead dollar expense for the work year?

  Projected cash outlay for 12 months = $197,944
  Less:
  Direct labor                        - $35,600
  Direct materials                    - $75,000
  Projected overhead expense            $87,344

5. What is the annual overhead percentage for Countryside Specialties?

  Yearly overhead expense = Annual overhead percentage 
  Yearly direct labor cost
  $87,344 = 2.453 or 245%
  $35,600

6. What will one package of lemon poppy seed muffin mix cost to produce?

  Average direct labor rate   = $ 8   /man-hr
  Overhead rate @ 245%        = $19.60/man-hr 
  Direct labor cost           = $27.60/man-hr
  4 man-hours per batch = 240 minutes/120 units per batch = 2 minutes per unit
  Direct labor cost/minute ($27.60/60 minutes) = $ .46 x 2 minutes = $ .92
  Direct material costs                        = $ .73
  Per unit cost of muffin mix                  = $1.65

7. What should Countryside Specialties selling price of this muffin mix be if the company wants a 25 percent gross margin on sales?

  Margin on selling price = $1.65/.75 = $2.20


Article and exercises provided by Alan F. Hauff, former MO SBTDC business development specialist and finance/pricing expert.