How Overhead Impacts Profitability

The typical kitchen and bath remodeling business cycle consists of a series of jobs that we do for clients. The usual practice is to analyze the job, figure a price based on what we perceive our profit needs to be, and then perform the job and collect the contract amount.

There are two parts to this process of job pricing: estimating our costs, and determining how much to mark up those costs to arrive at a selling price. While there are obviously market constraints that impact how much cost can be marked up in selling a project, there are some real constraints on the amount of gross profit that must be generated to cover overhead.

This month, we'll look at the elements of overhead, their relationship to the volume of our business and how to determine a markup that will cover overhead costs.

What is overhead?
The costs that a kitchen and bath firm incurs in the production of its products or services are broken down into two general categories: direct cost of sales and overhead. The easiest way to make the distinction between the two is that direct costs would not be incurred if we were not doing a particular job, while overhead cost would continue regardless of whether or not that particular job is being produced.

Since overhead is not directly driven by the level of our production volume, it's an area where business judgment plays a major role. Within the overhead category, there are elements that are somewhat fixed costs, and there are other costs that are variable. Fixed overhead costs include such items as rent, utilities, fixed asset costs, and the like. The variable elements are costs such as payroll, commissions, office supplies, and similar emphasis.'

As you can probably see, the relationship between fixed and variable overhead expenses is more of a continuum, with each type having a more or less variable character. It's only in the short run that such expenses are truly fixed.

The nature of overhead costs tells us that it's important to attempt to look ahead at our business to try to access sales volumes as accurately and as far into the future as possible. One of the realities of all costs, but overhead in particular, is that it's much easier to add to them than to reduce them. It should also be apparent that adding overhead of the relatively fixed variety, such as increased office space, is the most difficult to later adjust.

In theory, the most easily adjustable type of overhead should be payroll, since employees can be added or let go with reasonably short notice. In practice, however, there are several reasons that reducing employee levels is quite difficult. The most obvious reason is the human impact of layoffs and the associated implications for the company's morale.

A more subtle result of adding employees to your organization is the reorganization of the work load among employees. Once the tasks performed by one employee have been divided and some of them assigned to a second employee, it will be extremely difficult to reconsolidate this work load. The lesson here is that we need to make sure that employees are not added until we can determine that the need is significant and permanent.

Most overhead expenses are somewhat like employee levels in that it's easy to add things that become necessities that will later be difficult, or even impossible, to cut back on. In this category are various employee benefits and perks.
One of the most difficult types of overhead expense to judge is that of marketing and advertising. Since this is a cost designed to boost revenues, it's not one that you can, or should, adjust downward when business falls off. Here, again, the key is to make sure that you carefully evaluate the effectiveness of these expenditures.

Covering overhead
In evaluating the overhead levels of your business, it's important to be able to determine the point at which your production will produce enough gross profit to cover all of your overhead and produce a net profit for the business as a whole. This point is known as a "break-even" point.

Gross profit is defined as the difference between the direct cost of production and the sell price of that same production. If the amount of the gross profit is divided by the sale amount, it produces a gross profit percentage that is extremely useful in evaluating many business decisions.

The break-even point for your business can be determined by dividing the total overhead by the gross profit percentage (expressed as a decimal fraction). As an example:

Total overhead expense: $50,000
Gross profit percentage: 35%
Break-even point = 50,000/.35 = $142,857

In other words, $142,857 of revenue is needed to cover overhead expenses if gross profit on those sales is 35%.
Another useful exercise for this break-even formula is to evaluate the cost of additional overhead. Using the same formula as above, it's possible to determine that adding payroll and benefits for an additional employee costing $4,000/month will require additional revenue of $11,428 of sales to cover this cost.

Another use of this gross profit analysis is to evaluate the impact of changes in pricing strategies on the break-even point. Again, using the example above, if we increase our gross profit percentage by 1%, we see that our break-even point is reduced by nearly $4,000, to $138,889. Conversely, the effect of cutting prices to "get the job" can be seen by again using the same formula. If we were to cut the price on our jobs by 5% (a minimum amount of price reduction that would probably have an impact on a customer's decision to buy), we would have to increase revenues in our example above by nearly $24,000, up to $166,667, to cover the same $50,000 overhead.

Understanding the relationship between cost, gross profit, overhead and break even is critical for all of us as we attempt to make decisions about adding staff, increasing benefits or adjusting prices. As you can see from the examples, break-even analysis is not difficult to do, and you can even do a lot of this in your head as you evaluate decisions on a daily basis. Every time a decision is necessary with regard to increasing or decreasing expenses, estimate the impact on your break-even point before moving forward with it.

Next Column: When the Client Won't Pay.