How to Determine Overhead & Labor Rate
A critical element to making a profitable business lies in charging the customer enough for your services to cover all your costs, plus a profit. Many businesses set their prices by guessing what their customers want to pay or by using a competitor's pricing as a guide. By not recovering the true costs, those businesses are essentially working hard every day and possibly putting themselves out of business. In time, their labor and overhead costs erode their cash flow to the point that they cannot support their customers and the business fails. Determining your labor and overhead costs is an important step to managing a successful business.
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Things You'll Need
- Detailed accounting of the businesses expenses
- Information of non-cash benefits
Instructions
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Employee wages are the most significant labor cost, yet other costs, such as health insurance premiums, workers' compensation and the employer's contribution for Social Security and Medicare, will significantly add to these. There may be other non-cash benefits such as time off, training and uniforms that will add to the total cost of labor. Adding each cost on an annual basis will give you the total labor cost per year.
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Additional detail that may help a business manage expenses is to calculate the total labor cost per hour. This example assumes a business operating at 40 hours per week, with two weeks' paid vacation and five paid holidays. This provides for 1,960 production hours per year per employee. If the business has five employees, the total operating labor hours are 9,800. Take the total labor cost per year and divide by the total operating hours to calculate the total labor cost per operating hour rate.
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Overhead is defined as a business's non-labor costs. Such costs can include mortgage, supplies to run the business, bank loans other than mortgage and insurance. Other costs -- such as those associated with the advertising budget, travel, taxes, depreciation, legal expenses and accounting fees -- all contribute to a business's overhead costs. Review and total the accounting data for all expenses that are not related to labor to get your total overhead costs.
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These calculations will indicate only the cost of your business's overhead and labor. It is up to the marketplace to drive your pricing strategy to secure a profit margin to give you a return on your investment. It will also take solid management to have as many of the labor hours reflect true production hours. Many business assume a 7 to 15 percent rate of non-production time to their operating hours to account for low-producing employees. Good management, coupled with knowledge of your costs while continually driving costs down, helps expand your margin and grow your profits.
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