What Is Overhead? Understanding What an Accountant Means
May 15, 2018 | Accounting Help | No Comments
I know I need to understand my costs, but my accountant tells me my manufacturing overhead is out of line, “SG&A” needs to be controlled, and my prices are too low. I’m not sure I understand what she is talking about. What is SG&A? How do I lower my manufacturing overhead?
Trying to Understand My Accountant in Seattle
Dear Trying to Understand:
Accountant-speak can be overwhelming! Making heads or tails of the industry jargon is tough and it’s hard to grasp the root of the message. It’s hard to understand what an accountant means. What it comes down to is making sure you understand your business costs.
The first question to ask your accountant is, what is your conclusion based on?
Does she have specific industry data that she can share? If her findings are based on her experience with other clients’ financials, can she share generic information or a range of numbers? Keep in mind that businesses also select product positioning. Clarify if she is comparing you to her “specialty” clients–if you’re choosing the “low-cost producer” positioning the answer may not be as obvious.
Her basic conclusion is that you aren’t managing your costs. No matter what your company sells, if you don’t know what your product costs to produce, you can sell a lot and still not make enough money to pay your bills. Even low-cost producer positioning doesn’t mean “lose a little on each one and make it up in volume” – funny, yes, but you wouldn’t believe the number of companies operating under this false premise.
What An Accountant Means by “Costs”
A cost is anything you must spend to keep your business running. In manufacturing direct costs (immediate needs to produce your product) are material and labor. In service industries, direct costs are your people. Overhead costs consist of indirect costs that support the production of your product – management, buildings, insurance, and taxes. Overhead also includes costs to support the rest of the company: sales, general and administrative (frequently called “SG&A”).
Some costs relate directly to what you produce. When you produce a widget, let’s say it requires 3 woobles. If you make 10 widgets, you use 30 woobles. This is a variable cost because it changes in relation to the amount you produce. Fixed costs don’t change no matter how many widgets you make. For example, the receptionist’s salary doesn’t change whether you make 1 or 10,000 widgets a day. Your customers must pay for all these costs, plus a profit or you will go out of business.
(Just a side note here: Some fixed and variable costs are discretionary, and you can decide to spend or not spend. For example, you may decide to attend fewer trade shows this year thereby reducing the fixed cost of the entry fees and the costs of attending which might include travel and overtime pay.)
If you don’t have an accurate grasp on your costs, you won’t be able to judge whether to sell a product at the market price or if you have enough margin to reduce your profit to get a customer in a competitive market. In a quote situation, you’ll need to know whether you will make money with the price you quoted. If you want to stay in business (and stay sane) you must know, and control, your costs.
I know, that’s a lot to wrap your head around at first. Let’s break it down into categories. Some examples and further explanation:
Manufacturing Overhead (OH)
1. Fixed (typically the same cost each period)
- Salaried manufacturing employees
- Property taxes
- Equipment leases
- Warehouse rental
- Insurance (Worker Comp)
2. Variable (varies with production or use)
- Materials used in production
- Propane for the forklift
- Machine maintenance (ex. Grease gears after x units produced)
- Warehouse heat (varies by the weather)
3. Mixed (Fixed portion and variable portion)
- Utilities (Usually a base charge plus a usage charge)
Selling, General, and Administrative (SG&A)
1. Fixed (stay the same for a range of activity)
- Copier rent
- Trade show registration
- Marketing (once the budget is set)
- Office rent
- Office supplies
2. Variable (varies with activity)
- Overtime (OT)
- Wages for hourly employees
- Travel expenses
- FICA (Base and eliminated after reaching max)
What Your Accountant Means
When your accountant says your overhead is out of line, SG&A needs to be controlled and your prices are too low, she means: Overhead when compared to others in your industry is higher than might be expected. You can obtain some information to benchmark against your industry from a number of resources including: Robert Morris Associates (which I have heard has gotten very expensive), your local chamber of commerce, bank “common size” reports and industry comparisons that your accountant may have available.
Some areas to look at for savings would include:
- renting people or equipment instead of hiring/buying;
- eliminating excess production or warehouse capacity costs by moving or renegotiating current rates;
- staggering equipment start-ups to eliminate high base utility charges;
- scheduling maintenance to eliminate unexpected machine downtime etc.
The need to control SG&A refers more to discretionary spending rather than the fixed/ variable components:
- Did you hire staff “in anticipation” of a sales increase that has not happened?
- Are you attending more trade shows than can be cost justified?
- Would streamlining your processes require fewer staff?
- Does your commission structure encourage the performance you expect?
Depending on your product, the market controls prices for some products (ex. Do you select your gas station based on price or the juice selection?) or if the product is not a commodity, you may be able to set the price of your product.
The references above will also give you some idea of what margins and profits look like in your industry. The difficulty in product pricing outside of market forces is how to allocate the overhead (manufacturing and SG&A) and a level of profit to the product.
Another problem that I encountered in the past, excess capacity. Maybe you lost a large customer, or the market shifted to another product or other factors that leave you with excess equipment, space etc. This is where the fixed costs mentioned above can eat you alive. Fully allocating your fixed costs to your product may make it too expensive for the market, but not allocating causes cash flow issues. I will address this in a future blog. Suffice it to say – you must figure out how to reduce fixed costs.
- Compare your costs to others in the industry and identify where they are out of line.
- For each cost identify the activity the drives how that cost increases or decreases (cost drivers) with that activity
- Identify which of the cost drivers that management can control or influence
- Implement strategies to drive those costs in the right direction
- Or, if the market will bear it adjust your prices to alleviate the problem.
I hope you can get your costs and pricing in line and be sure to look up how to manage a cash flow crisis if these problems are severe.
All images by rawpixel on Unsplash.