Understanding cost drivers

A few years back, I was brought in by the president of a small business which manufactured and installed custom storage systems for offices and restaurants.  His concern was that either his accounting system had a bug in it or that someone was stealing from him.

This came to light when he ran his most recent quarter profit and loss; it seems that for the first time in over 7 years, he lost money.  His shop has never been busier.  He is getting lots of highly profitable contracts so the quarterly results don’t make any sense.  I asked to see quarterly information and got to work.

The first report I reviewed was the profit and loss report.  Sure enough, there was a $53K unabsorbed overhead amount  This happens in one of two ways – quarterly overhead went through the roof or the driver, in this case direct labor hours, were substantially lower.  Sure enough, the direct labor hours were down about 10%, indicating that labor wasn’t recorded.  Which would be really strange as the controller had been doing this job for almost 5 years and consistently made the overhead allocation adjustment correctly.

overhead1

So I asked the president if there were any major changes.  His response was that he decided to outsource all of his installations.  As a test, he explained,  the company in the prior quarter elected to put the installation out to bid on one project and the price came in at about 60% of what his costs were.  So he decided that he was going to “sell” the installation department to his department supervisor who would then quote jobs as an independent contractor.

I explained to him that what he was seeing was a direct result of the decision to outsource without knowing all the available facts.

Fact: There were two different departments, each with its own overhead costs and driver

Fact: the Company was using a single driver addressing the total overhead

Conclusion: The same (essentially) overhead dollars were being allocated over fewer direct labor hours, leading to larger unabsorbed overhead since the rate was not adjusted to reflect that fewer hours were being “sold”.

I then showed him a spreadsheet of what this actually looked like:

overhead2.png

The company rate of $41 was correct, but only for its overall purpose, allocating company overhead to production costs.  In reality, very little of the overhead went to support the installation department.  As a matter of fact, when separated, it became obvious to him that the shop was being subsidized by the installation department.

When they bid a job and included the rate of $41 to the install hours, the company was in fact generating an additional $27 in revenue which went to the bottom line.  But this was hidden from the controller, the president and the estimating department.  Thus, the $100 per hour revenue rate appeared high when compared to the $75 rate that the subcontractor offered.

In truth, had the company been facing lost estimates, they could have reduced the hourly rate for installations from $100 to about $65 and still earned a decent profit.  But you have to look deeper into your company structure in order to understand that options like that are available to you.

When most of your costs are fixed, then basing make or buy decisions on your overhead absorption rate can be dangerous.  The key is understanding that allocating costs by way of hours turns that fixed cost into an illusory variable cost.  You begin to think that by eliminating the driver, the cost goes away as well.  It doesn’t work.

Once the president understood this, he was able to convince the installation team to rejoin the company, although he did have to make some concessions as to bonuses when it came to profit earned on installation jobs.  And with this information, the company went through the various areas of the business and examined how costs were incurred and allocated to projects to even more effectively estimate contracts and keep their bids competitive while improving their profitability.

 

Understanding Overhead

When I first start evaluating a financial statement, I try to group costs together logically.  It is far too typical for most businesses to rely upon the canned reports and these are almost always prepared in GL Number order.  But a clearer picture can be developed by grouping the costs of revenues separate from the overhead and the overhead into 4 main groups.

The overhead groups I prefer follow the Throughput model:

  • Labor Overhead
  • Marketing Overhead
  • Facilities Overhead
  • General

A little bit about the groupings:  Labor overhead includes not only those who are on payroll but also consultants and outsourced staffing.  So, for instance, if your company outsources janitorial services, this expense is reported in labor, not facilities.  My approach is to put all labor into labor overhead, including production labor, unless it is truly variable – which most is not these days.

General is the catch-all classification.  There are two services I typically would group into general – legal and auditing.  While both are still people performing services, these are services which your business typically cannot provide internally.  Otherwise, if it cannot clearly fit into one of the other three groups, put it in general for now.

Let’s say your business does $1.0 Million in sales monthly.  Your direct material costs are $350K and you have depreciation on equipment which manufactures the products you sell of $50K.  Throughput, which is the measure of how much money you generate to cover overhead and profit, is $600K.

Continuing our analysis:

  • Labor Overhead runs $400K  or 66.7% of throughput
  • Marketing Overhead is $50K  or 8.3% of throughput
  • Facilities Overhead is $50K or 8.3% of throughput
  • General Overhead is $30K or 5.0% of throughput

In total you are spending $530K to generate $600K of throughput.  88.3% of every dollar you bring in is consumed by your overhead, of which most is tied up in labor costs.  You see, when you separate out your labor into different categories, such as production labor, sales commissions, accounting and office staff, you can lose sight of the total amount you are spending to generate throughput.  It isn’t that these separate amounts are not important, but when you are looking at leveraging your business, having expenses scattered everywhere can lead to a misunderstanding.

Properly grouped, we can start analyzing.  There would be two points of reference to the analysis, average and best case.  Both of which can be found in the prior year’s records.  For the average, I would recommend taking the last 5-7 years of information and reformatting to match the groupings above.  You are looking for a trend and what you will likely find is that throughput has remained fairly steady but labor overhead has crept up.  It isn’t necessarily bad, but it does indicate that more money is being paid out for peoples time but the company is not getting much in return.

The comparison to best case can be a real eye opener though.  Here you find the year where there was the most profit and then compare where you are today with the overhead structure in place when the company made vast profits.  In almost all cases, you will find that the company increased spending across the board relative to that maximum profit year.

So, instead of giving a bonus to the employees and management, the company raised base compensation.  The company went from a 50,000 sf facility to 100,000.  When you study this great year you start realizing that perhaps it was luck and you were betting it would continue – only to find out it didn’t.

GAAP statements have their purpose.  But managing to GAAP can be dangerous to the bottom-line.  It is all too easy to want to capitalize everything into your inventory but that means that today’s costs are probably being buried and will be recovered in a later year.  But in the meantime, your costs are possibly growing out of control which is impacting your current cash flow picture and may even hurt you in the future if you have to reduce prices to be competitive.

Consider using the Throughput model for evaluating your internal financial statements.  I think you will be surprised at how much information it can provide you to help you make better business decisions.

If you would like more information or would like to discuss how effective analysis can help you understand your operations and profitability, feel free to contact mecontact me anytime.  I am here to help.