PREDICTING OVERHEAD FOR A PRODUCT BUSINESS
I want you to think of a person standing outside in the rain with an umbrella over their head every time I say the work overhead. The word taken in its most literal form means something that stands over the head of something to make sure all parts are covered.
Overhead expenses in business is the catch all for other expenses that does not fall into your direct material and direct labor cost.
Every business has 2 categories of cost
Every business has 2 categories of cost namely:
- Product cost – are cost associated with the production of your product or service. Product cost starts out as inventory and becomes cost of goods sold when sold. Product cost is made up of direct materials, direct labor and manufacturing overhead.
- Period cost – gets its name from the way it is recognized in your accounting records. Period cost is accounted for in the same period it happens. Essentially, period cost are the costs that are necessary to run a successful business but not needed to make a finished product.
To keep this concept simple, I will be discussing only overhead involved in product cost here. My next article will discuss overhead classified as period cost.
Overhead associated with making your product
Previously, I mentioned that overhead consists of direct materials, direct labor and overhead cost. In this section, we break down overhead cost even further. Overhead associated with making your product can be broken down into indirect labor, indirect material and general overhead used in production.
- Indirect material and indirect labor: Included in overhead, are labor cost and materials needed to finish your products but not directly used in the production of the product. An example for my bakery, is someone is needed to move inventory from the storage space to the kitchen. While this is necessary, it is not a part of directly making the product.
- Indirect- other: this is the catch all for all expenses not directly related to production. An example will be rent expense.
A prudent business owner keep overhead in line with business activity. The activity level in a business, are the set of activities that allows the business to meet the sales budget. With that said, smaller businesses need less overhead while bigger business usually but not necessarily spend more on overhead.
The mistakes some entrepreneurs make is engaging in more activities than is needed to meet the sales projection
Steps to predict overhead
Follow these steps to predict overhead:
- List all business activities
- Carefully detail what is needed to bring these activities to past
- Figure out the cost of one unit of the activity
- Determine a buffer
- Predict total cost based on activity level
First, list all business activities
Your overhead is determined by the level of activities needed to support your sales forecast. In “My Cake Shop”, I start by describing my processes and list what activities are needed to support them. After brain storming, I come up with the following five main categories of activities:
- Purchasing materials & supplies
- Moving inventory
- Preparing the ingredients for baking
- Baking the cake
- Cleaning up after baking the cake.
Second, carefully detail what is needed to bring these activities to past
Every activity will need one of the following types of overhead to come to past ( we have already talked about direct material and direct labor and will not be including them here)
- Indirect material
- Indirect labor
- Indirect- other
Below is the breakdown of activities in “My Cake Shop”
Notice how careful thought is given to each activity. One major advantage of budgeting is the owner can see how much time is needed to run his or her business. In the image above, you can easily see how many hours I am planning to devote to the business. As I become more profitable, I can hire out some of these tasks.
Third, figure out the cost of one unit of activity
To figure out the cost of one unit of activity, you will need to break down the cost to variable and fixed cost.
- Variable cost: with variable cost, the price you pay for each unit does not change (or changes insignificantly during our budget year). An example will be detergent. We estimate variable cost by using the average price of one unit over a year. For example if on average I pay $5 for cleaning supplies, then my cost per unit is $5.
See the example for “My Cake Shop” below:
- Fixed cost: fixed cost is cost that stays the same from month to month. An example will be rent. Estimate fixed cost per unit by :
- Figure out annual cost: For example if my monthly telephone bill is $80 a month, then my annual cost for operating the device is $960.
- Estimate daily usage: It is important to note that you are not estimating based on what you need to make your product, but the total usage for the year. For example, if I am on the phone 50 minutes a day, I will estimate my total usage to be 50 minutes * 365 days. Some of these minutes might be personal and some of them might be for the general administration of my business (this is a topic we will visit later).
- Figure out the cost per unit: Cost per unit is annual cost divided by estimated daily usage
See an example for “My Cake Shop” below:
Fourth, determine a buffer
Life does not always go as planned. When you plan a budget, include a buffer to account for the unexpected. Based on past experience, you should be able to estimate how much buffer to add.
Buffers should account for wastage, unplanned activities, changes in the external environment. If you live in an unstable economy, you will need a lot of buffer in your budget. For example, let us say you live in a city where the landlord can change the rent at any time. Let us also assume your monthly rent is $500. In the past your landlord has changed the rent once during the year at a 5% rate. If this is the case, you will need to add 5% buffer before finalizing your cost estimation. For my bakery, after careful analysis, I decide I do not need a buffer for my fixed expenses since I usually have contracts that guarantee the rate for the year. However, I decide to add a 5% buffer for variable cost as shown below:
Lastly predict the cost for these activities
Lastly, use the equation below to predict the cost for these activities:
Overhead cost =Activity level * buffer percentage * cost per unit.
See the illustration above for variable and fixed cost.
Activities are good predictors of overhead. By knowing what is required of your business, you increase your chances of succeeding. Using activities to predict overhead is more efficient than historical data as it forces you to stop and ask “what is needed?”
Asking what is needed is crucial especially if you exist in an industry where the speed of discovery is quite fast. Overhead cost could change rapidly due to the betterment of technology, number of substitutes available, etc. This causes the cost of goods to go down.
The long and short of this article is, “Know thy business!!!!”