Costs are the expenses a company makes in order to make a profit. Hence, knowing whether a cost contributes to the company’s profitability or not is the basis of cost management.
If we take a company as an example (i.e. law or an accounting firm), that has $2m in income and $1.3 in expenses, the profit will be $0.7m, and the net profit rate is 35%, which is, we’ll assume, above the industry average.
However, we have to ask ourselves how much do these expenses contribute to generating profit.
To know this, we need to calculate the individual profitability per business unit, or, even better, per project.
Profit per business unit
In the following report we will notice that, even though the company has made a great profit, once you observe the analysis by the business unit, not all business units brought profit.
Business unit 7 and business unit 8 generated expenses larger than the income of those business units, so they generate a loss of $15.000 and $50.000, respectively.
A more adequate cost management requires these analyses, not only per business unit but also per employee and individual project.
Good cost management answers the question of which costs to reduce, and where you should invest more
According to the assessment, 80% of professional service companies don’t have the information about the projects that cause them losses, nor which employees can’t cover the costs allocated to them.
Is there a project, employee, or business unit in your company that generates a loss, or, in other words, costs you?
Answering this question doesn’t have to be very difficult if you have a good expense allocation mechanism. De facto, the income isn’t a problem, since you can easily see the invoices for each project through accounting. However, if there are the costs of salaries and office lease, the question arises – how to allocate those costs per unit, employee, or project?
Allocating the costs per employee, project, and client
You need to determine the allocation key to conduct this allocation. When we are talking about professional service companies, the allocation key should be connected to the most important resource, which is employees’ work, namely, their work hours.
You can allocate the salary expenses depending on which employee spent a number of hours on a specific project.
The price of a specific employee’s work hour is calculated as the ratio of the employee’s total costs and the average number of their work hours for a specific period. For example:
How can the hourly rate contribute to cost management?
Simply enter these pay rates into yours.
When the employees log their work time, the timesheet program will allocate all costs by different categories.
You will get different reports, such as the scope of the expenses per project, client, and work task. You will get the gross profit for each category by comparing those expenses.
The gross profit margin (the difference between the profits coming from sales and the work costs) is a good indicator for profitability assessment by the project or unit. However, it is even better if you’re able to calculate the net profit margin (the difference between the profit and the sum of work costs and overhead expenses).
How to calculate the total costs per project, unit, or client?
Following the logic for allocation we’ve described above, it is also possible to calculate all overhead expenses per hour.
Of course, the calculation can’t be 100% exact, since you will be using allocation keys. Allocation keys are a form of the most accurate estimation, but the results you’ll get this way are very reliable for better cost management.
The goal is to get the total expenses per hour following this formula:
Cost rate = Pay rate + Overhead rate
So, the table above is supplemented with additional columns, so you’ll get the total cost per hour:
Once we allocate the overhead expenses per project or service line, we’ll see how much of a burden they are to the projects, and where the loss is coming from.
You can do that by entering the aggregated (cost rate) into the time tracking software.
The employees log their time, and the program automatically allocates the costs to the projects, clients, and tasks each employee is engaging with.
The time tracking program delivers the reports which answer the following questions:
- What is the total cost of a work task?
- How much does a specific project cost?
- What are the costs of a specific service line?
If we compare these expenses per project to the profit per project, we’ll easily identify the projects with a profit below or above the expected.
How to manage the costs of units that are generating a loss?
If we determine that profitability isn’t appropriate on the individual project or employee level, we need to take the following action.
What are the potential causes:
- The employee hasn’t been productive enough, so they used more time on a project than they realistically need
- The structure of employees working on a project isn’t appropriate because the majority of the employees have higher hourly rates
- The scope of the task wasn’t assessed well, so the fee you’ve agreed upon is significantly smaller than the one that made sure you got the desired profitability
- You needed to use manufacturer services, which increased the expenses
- The project is strategically important, so the potential loss represents an investment for future collaboration
As you see, the problem can come from the employees or the clients.
If the problem is caused by the employees, you need to consider the following:
- Finding out why the employee hasn’t been more efficient, and have a conversation with them
- Is this inefficiency a one-time mishap, or is it repetitive
- Would investing in the employee’s development to be more efficient be worthwhile
- Do you need to rotate the employee – give them a less responsible position
- Should you stop the collaboration with the employee
If the problem comes from the client, you should:
- Consider the contractual terms with the client
- Suggest an increase in fees for future engagements
- Assess the expected profitability more accurately before starting a new engagement
- Consider potential termination of the contract
What is the expense policy for the units that generate profit above average?
Bonuses and rewards are the best stimulation for your employees. If you don’t have an adequate cost management mechanism, and you can’t determine how much profit each employee brings, your bonus policy will probably be wrong.
Hence, it is important to have an insight into the income and expenses of each employee specifically, so you can decide who deserves the biggest bonus. Of course, this is applicable if the financial component is significant in determining an employee’s goals.
However, you need to be cautious. In other words, monitor how a top performer’s bonus impacts the increase in the profit they generate. If the increase or raise of the top performer, or the bonus they get results in a larger increase in profit, you have a win-win situation.
That is why once you have this type of analytics, you can define employee goals accurately and reward them accordingly. Additionally, you can set goals so their completion means both a higher compensation for the employees and increased profit for the company (another win-win position).
Analyzing client costs
If you determine that your company generates a higher-than-average profit with some clients, that is a clear sign you should allow a more generous budget for said clients. In other words, instead of investing in business relationships with all clients, you will optimize your investments and focus on those that give your business a greater value.
We will focus on the category of overhead expenses in the following section.
Which costs are included in overhead?
Overhead costs are the business expenses that don’t relate to creating a product or offering a service directly. Understanding your overhead costs is significant for the budgeting process and determining how much you should charge to make a profit. That is to say, overhead includes all costs made in order to support a company that aren’t directly related to the specific products or services the company provides.
- Overhead costs represent the ongoing expenses needed for a business to operate. They don’t include the costs that relate to creating products and services.
- Overhead can be variable, fixed, or a combination of both.
- There are many different categories of overhead, like administrative overhead, employee perks, office expenses, etc.
- The income statement should include overhead costs.
Overhead expenses don’t depend on the current state of business. They have to be paid regularly regardless of the number of sales. For example, a company with a physical location must pay for office lease, utilities, insurance, and office supplies, and add those expenses to the direct costs (like supplies and salaries) necessary to provide your service or create a product.
Overhead expenses directly impact a business’s profitability. That is why they are included in the income statements of the company. They have to be accounted for if you are planning to calculate the net income (also known as the bottom line). You can calculate the net income by subtracting all overhead and production-related expenses from the business’s net revenue (also known as the top line).
When we say overhead expenses are fixed, that means the amount you pay is the same each time you’re paying. On the other hand, variable overhead means the expenses are dependent on the level of activity. For example, a company’s office lease is usually fixed, while other expenses, like printing and different office supplies, are variable.
There are also semi-variable overhead costs. That means one part of the expense is constant, while the other is dependent on the business activity level. The best example is utility costs, which have a base charge and additional expenses depending on usage.
Overhead cost examples
Each business is different, but most companies have the following overhead costs:
- Administrative costs
- Employee perks
Rent and Utilities
These overhead expenses relate to the maintenance of the company’s offices and/or manufacturing space. Each company has these expenses, no matter its industry. Rent and utility costs include office lease but also utilities like electricity, phone and internet service, water, heating, etc. there are also the costs of specific subscriptions for software employees use (Zoom, Slack, Trello, etc.).
These costs often account for the bulk of a business’s overhead costs. They include office supplies, office associates’ salaries, external audits, and legal fees, etc. they are also the most diverse in scope and significance, and can range from restocking soap to hiring a consultant to help the company find the best way to conduct its business in its current circumstances.
Even though the types of insurance are numerous and vary depending on the industry, all companies need to be ensured to function in the best way. Insurance can range from property insurance (making sure the space, equipment, and supplies are protected from the elements and theft), to health insurance for the employees, to professional liability insurance. Additionally, if the company owns any vehicles, they also need to be insured. It is clear that these expenses don’t directly contribute to the business’s revenue. However, they represent good business decisions and are often legally mandated.
It has become a standard for larger companies to offer at least some benefits for their employees. for example, many offices provide coffee, juices, tea, snacks, etc. Other examples include parking, gym memberships, company vehicles, retreats, and different team-building activities. Even though these perks may incentivize employees to invest more effort into their work, the expenses don’t directly impact the product or service the company provides, and thus, fall under overhead costs.
Types of Overhead
Many types of operational categories are considered overhead expenses. For example, hiring accountants, HR, and receptionists are considered general/administrative overhead. On the other hand, the activities related to sales and marketing are considered sales overhead. Sales overhead may include making promotional material, paying for TV commercials, but also the commissions of the sales team.
The industry and nature of the business determine other categories of overhead. For example, some companies require research, manufacturing, transportation, or maintenance overhead.
Overhead usually applies to the entire company operations. That is to say, it is usually considered a general expense. Most often it accumulates as a total sum and then can be allocated to specific projects and departments.
Determining the function of different expenses is necessary to manage them in the best possible way. That means you need to assess the way the costs burden profits on the individual project, employee, and client level.
If you have a good time tracking system, you’ll need to determine each employee’s hourly rate, which is the sum of their pay rate and overhead rate. Allocating the time to projects and clients through time tracking will give you reports which enable you to calculate the profit for each client, project, and employee individually.
Based on that, the company can manage its expenses more rationally, or, in other words, optimize the costs invested in employees and clients which generate or don’t generate the desired profit level.
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