How to Handle your Overheads

No matter your industry, your business has overheads. In the past, the cost of 'keeping the lights on' could be simply overlooked by most small businesses. If you had a decent gross margin, your overheads took care of themselves. Today however, with costs higher than ever and margins being squeezed tighter every day, properly handling your overhead costs can be the difference between success and failure. The best method I have found to do exactly that is what's known in accounting as the 'Overhead Absorption Rate' costing method, or 'OAR', because we all know how much accountants love three letter acronyms. During this post, I will simply explain how this method can work for you. While it sounds complex, it's actually unbelievably simple to understand.

Absorption Costing
​Absorption costing allows us to capture all costs associated with manufacturing a product or providing a service. It's very simple to get your gross profit margin, for example, if you produce a chair and sell it for €100, you spent €30 on materials and €20 paying a man to make it, then you have a gross profit of €50 on that chair. That's fine if you made just one chair, but what if you are running a factory  producing hundreds of these chairs every week? You aren't making €50 per chair, because you have to pay for renting the factory, for electricity to run the machinery, for admin staff to actually sell the product. Even with a gross margin of €50 per chair, for all you know you could still end up making a loss. That's where absorption costing comes in. Instead of just guessing like most of us do, it allows us to accurately break down all these overheads into an individual cost per unit. So for our example, we can say that all of our overhead costs are actually working out at €40 per chair. This means for every chair we make, we have a net profit of at least €10. And what makes this method so special is that the €10 is actual net profit, there's nothing left to pay out of that. 

Calculating Your Overhead Absorption Rate 
Arriving at an overheads per unit figure is actually quite simple. First, we establish our total overhead costs. This should include every single cost of doing business, down to what can seem like the most insignificant of details. We can also include depreciation here if your business is capital intensive, because your fixed assets need to be paid for as well. You may think that it's then just a matter of dividing that figure by the number of units produced, which is technically correct, however; that would only work if you produced just one type of product. Returning to our example above, we might be producing ten different types of chair, all using different amounts of materials, taking up different amounts of time in the factory, but all using the same overheads. In order to accurately absorb our overheads into each product then, we must decide on a suitable metric to break down our overheads into, for example labour hours. We could take the total number of labour hours in our period, and divide our total overheads by this. That provides a figure for overheads per labour hour, which is called the Overhead Absorption Rate (OAR). Lets take a look at our chairs again. Say our overheads are €8,000 in a week and each week has 400 labour hours. Our overheads per labour hour, or OAR, would be €8,000/400hrs = €20 per hour. We then know that if chair A in our range takes up 2 labour hours in the factory, we apportion €40 of overheads to it (2x€20).  There are numerous other metrics which could be used, such as materials in the product of machine hours, but regardless of that the calculation works in the same basic way. 

Why OAR
There are countless benefits to using this costing method in your business, but one of my favorites is gaining a clear figure on precisely how much could be saved by scaling up your operations. As most of you know, overheads shouldn't change much relative to production, meaning that doubling production shouldn't have much effect on your overheads. Bearing that in mind, we can then simply work out the effects of increasing production on our margins. In our chairs example above we had total overheads of €8,000 per week, and 400 production hours. For the sake of explaining, say we doubled our production to 800 hours per week, and kept our overheads constant. This would mean that instead of having a €20 OAR, we would have €10. As above, this would mean chair A taking 2 hours to produce now has €20 overheads allocated to it as opposed to €40 previously. The absorption costing method is by far the best way to look at economies of scale, and lets us see how it can apply to our organisation, regardless of our size. 

In addition to the above, it can also help us outline areas where we need to improve. If a certain product seems to be taking up an enormous chunk of the overheads because it spends much longer than any other in production, then perhaps this is something we need to look at. It's worth mentioning here that there is a further layer to absorption costing which can be applied; Activity Based Costing or ABC. This is where instead of taking the total overheads as we did above, we instead group the overheads into different areas, such as factory, admin, procurement, delivery, etc. We can then prepare separate OARs for each category of overheads, and allocate them one by one to the products. This allows us to look even deeper into not only which products use most overheads, but where. If we have a product that say takes a long time to produce, but doesn't have to be delivered, or have much admin or procurement work done on it, then the overheads from those other areas should not be apportioned to it, just the factory overheads. This further allows us to look at which areas of our overheads are hurting us most. 

Finally, the main real-world benefit of applying this method is that it simply allows us to know exactly what our products cost us to make. This small piece of information can be more useful as a decision making tool than any other metric that could be measured in your business. How can you agree a sales price if you don't know your exact cost? How can you try improve efficiency to cut costs if you don't even know what those costs are? In my own opinion, having an accurate total cost per product is an essential first step in any decision making or improvement process in your business, and the OAR method is the best way to get there. 

As always, I'd like to thank you for taking the time to read, and I hope it has been of value.  If you'd like to get in touch with any questions, or to learn more about Overheads and Absorption Costing, please do not hesitate to leave a comment below, or reach out to us at [email protected] .

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