bonus: nine specific illustrations.
by ed mendlowitz
77 ways to wow!
most business owners look at the total payroll in dollars and go no further. but – payroll numbers are useful only if you drill down several levels to determine …
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head count
i tell clients to keep track every month of the total head count of the business – whether it’s three, 10 or 100 employees. on a year-to-year basis, the head count can be very revealing. first, it tells you whether employment is growing faster than you realized. second, by comparing head count with unit sales, you can measure worker productivity. if there is growth in units sold, your payroll is in good shape. if growth of units per employee declines, you have a problem that needs immediate attention.
overtime
have your bookkeeper create a separate general ledger account for overtime wages. a quick look at that number every month shows you immediately whether your overtime is moving higher or lower. note that the change is what is important, not the actual amount because many businesses through unstated convention provide the opportunity for certain employees to earn additional income by allowing them a fixed amount of weekly overtime. noting the changes and comparing them to increased or decreased production provides a check on whether it is valid, or costs are just creeping up.
fixed vs. variable payroll
payroll in most businesses is a fixed overhead item – not belonging in variable or adjustable direct cost categories – and management’s thinking. in most businesses, payroll, other than sales and office payroll, is reflected as a percentage of sales indicating that it changes in a uniform percentage as sales increase or decrease. however, that is not usually reality. businesses cannot turn on and off payroll as sales or production ebbs and tides – making it a fixed item. even overtime cannot always be reduced so quickly. managers need to understand the actual nature of the payroll. using labor costs as a percentage of sales can distort the actual operations and profitability of the company or division.
on a long-term basis, direct labor must be considered as variable because it will expand or contract as sales grow or decline. however, on a short-term basis that is not usually the case. i have had clients that were union manufacturers and if they knew at noon that they did not have enough work for a full crew for the next day, they would lay off the appropriate number of production employees. while this was not that fair for the employees because they would lose a day’s pay this was in accordance with the collective bargaining agreement, as were other items that conferred a benefit on the employees, so i guess it all balanced out in the end. in those clients’ cases, which weren’t that many, direct labor was truly variable.
illustration: calculating actual payroll costs
in controlling payroll costs, it is very important to know what the actual payroll costs per hour are. once that is determined, the labor factor can be calculated with some degree of accuracy.
following is a schedule of the typical number of days worked.
actual hours worked in a year
| (1) | (2) | (3) | (4) | ||
| number of days in year | 365 | 365 | 365 | 365 | |
| less: | |||||
| weekends | 104 | ||||
| vacations | 10 | ||||
| sick days | 5 | ||||
| holidays | 10 | ||||
| non-allocable personal days | 3 | 132 | 132 | 132 | 132 |
| total workdays | 233 | 233 | 233 | 233 | |
| less non direct labor days (±15%) | 33 | 33 | 33 | 0 | |
| total billable workdays available | 200 | 200 | 200 | 233 | |
| number of hours worked in a day | 7 | 7 | 8 | 8 | |
| less time not actually working | 1 | 0 | 0 | 0 | |
| hours actually working | 6 | 7 | 8 | 8 | |
| number of actual hours worked in a year | 1200 | 1400 | 1600 | 1864 | |
this is a model of a way to calculate the labor cost per hour. as such, it needs to be adapted by each business to fit their situation. for instance, many manufacturing businesses use an 8-hour day – with almost no “non-direct labor days” – but they should allow for down time waiting for materials or for a machine to be repaired.
the big picture point here is that we don’t believe personnel works as much as the owners believe they do or that they are paid for.
illustration: cost per hour, based on actual hours worked
the following are calculations of the cost per hour worked using two scenarios. obviously, the following can be used as a model that can be adapted to any business situation.
| % of salary | costs (1) | costs (2) | ||
| base salary | 100.00% | 50,000 | 100,000 | |
| fica | 6.20% | 3,100 | 6,200 | |
| medicare | 1.45% | 725 | 1,450 | |
| ui/di/fui and other payroll taxes | 1.50% | 750 | 1,000 | max |
| workers’ compensation | 3.00% | 1,500 | 3,000 | max |
| liability insurance | 1.00% | 500 | 1,000 | max |
| pension or 401(k) match | 3.50% | 1,750 | 3,500 | |
| union or other costs | ||||
| medical insurance, per employee | 10,000 | 10,000 | max | |
| other direct costs of employee (computer, office, payroll service, telephone and communications, dues, supplies, coffee and munchies, lunches brought in, gifts, travel, entertainment), per employee | 6,000 | 6,000 | max | |
| continuing education and training | 2,000 | 2,000 | max | |
| total cost | 76,325 | 134,150 | ||
| extra costs as a percent of base salary | 52.65% | 34.15% | ||
| actual hours worked or chargeable and cost per hour | 1200 | 64 | 112 | |
| 1400 | 55 | 96 | ||
| 1600 | 48 | 84 | ||
| 1864 | 41 | 72 | ||
illustration: 20% overtime hours at straight time rates
the following assumes that 20 percent of base salary will result in overtime and that the overtime will be paid at straight time rates. the straight time isn’t reality because there are labor law requirements to pay time and a half. however, this can serve as a comparison to the time and a half calculation to see the overtime premium. further, some businesses are permitted to pay straight time under certain circumstances.
| % of salary | costs (1) | costs (2) | |
| base salary | 100.00% | 10,000 | 20,000 |
| fica | 6.20% | 620 | 1,240 |
| medicare | 1.45% | 145 | 290 |
| ui/di/fui and other payroll taxes | 1.50% | 150 | |
| workers’ compensation | 1.00% | 100 | |
| liability insurance | 1.00% | 100 | |
| pension or 401(k) match | 3.50% | 350 | 700 |
| union or other costs | |||
| medical insurance, per employee | |||
| other direct costs of employee (computer, office, payroll service, telephone and communications, supplies, dues, coffee and munchies, lunches brought in, gifts, travel, entertainment), per employee | |||
| continuing education and training | |||
| total cost | 11,465 | 22,230 | |
| extra costs as percent of base salary | 14.65% | 11.15% | |
| chargeable hours and cost per hour | 240 | 48 | 93 |
| 280 | 41 | 79 | |
| 320 | 36 | 69 | |
| 373 | 31 | 60 | |
illustration: 20% overtime hours at time and a half
| % of salary | costs (1) | costs (2) | |
| base salary at time and a half | 100.00% | 15,000 | 30,000 |
| fica (limit not applied to illustration 2) | 6.20% | 930 | 1,860 |
| medicare | 1.45% | 218 | 435 |
| ui/di/fui and other payroll taxes | 1.50% | 225 | |
| workers’ compensation | 1.00% | 150 | |
| liability insurance | 1.00% | 150 | |
| pension or 401(k) match | 3.50% | 525 | 1,050 |
| union or other costs | |||
| medical insurance, per employee | |||
| other direct costs of employee (computer, office, payroll service, telephone and communications, supplies, dues, coffee and munchies, lunches brought in, gifts, travel, entertainment), per employee | |||
| continuing education and training | |||
| total cost | 17,198 | 33,345 | |
| extra costs as percent of base salary | 14.65% | 11.15% | |
| chargeable hours and cost per hour | 240 | 72 | 139 |
| 280 | 61 | 119 | |
| 320 | 54 | 104 | |
| 373 | 46 | 89 | |
illustration: hourly cost summary
here is a summary of the hourly rates under the various situations.
| salary | regular hours | ot hours | total hours | regular pay per hour | straight pay ot per hour | time and a half ot per hour |
| 50,000 | 1200 | 240 | 1440 | 64 | 48 | 72 |
| 1400 | 280 | 1680 | 55 | 41 | 61 | |
| 1600 | 320 | 1920 | 48 | 36 | 54 | |
| 1864 | 373 | 2237 | 41 | 31 | 46 | |
| 100,000 | 1200 | 240 | 1440 | 112 | 93 | 139 |
| 1400 | 280 | 1680 | 96 | 79 | 119 | |
| 1600 | 320 | 1920 | 84 | 69 | 104 | |
| 1864 | 373 | 2237 | 72 | 60 | 89 |
for manufacturers, the hours worked are important because one way of allocating overhead to the manufacturing process is to determine the expected annual hours and then divide the total overhead by that number to arrive at an hourly rate for overhead. in other cases, the projected total annual overhead is divided into the total projected payroll costs and that percentage is applied to the payroll costs for each job or project.
if employees can work a greater number of hours, then obviously additional profits will result. if fewer hours, then less profits. in service businesses it might also be typical for some of the non-working time to be billed and considered as part of the working time. for instance, taking a break to go to the restroom or a quick call a couple of times a day to a spouse. in those cases, the actual billed hours might be higher, and the total of the number of hours worked would thereby be adjusted.
illustration: payroll cost per department
this sample schedule shows the total cost per employee and number of employees in each function. the management department payroll is much higher than the others and skews the total results, so the total payroll is shown with and without management included.
illustration: direct labor cost analysis
the following sample schedule gives a breakdown of the direct labor. note that these amounts tie into the totals in the payroll cost per department schedule above. the totals are 51 employees with a payroll cost of $2,960,241. this shows a detailed breakdown of the elements making up the total payroll cost.
when employees clock their time, they are measuring the actual hours worked and not what they are paid for. therefore, the actual hours worked are divided into the total payroll cost, giving a higher hourly cost because the cost of the hours not worked are taken into account, based on the hours actually used in production. notice that the non-worked hours is 13 percent of the total paid-for hours.
| payroll – direct labor | widgets | bitgets | citgets |
| payroll regular | 1,225,000 | 360,000 | 350,000 |
| total overtime paid | 183,750 | 54,000 | 52,500 |
| total paid | 1,408,750 | 414,000 | 402,500 |
| # of employees | 35 | 9 | 7 |
| fica | 87,343 | 25,668 | 24,955 |
| medicare | 20,427 | 6,003 | 5,836 |
| ui/di | 35,000 | 9,000 | 7,000 |
| workers’ compensation | 84,525 | 24,840 | 24,150 |
| liability insurance | 28,175 | 8,280 | 8,050 |
| federal unemployment | 1,960 | 504 | 392 |
| pension | 49,306 | 14,490 | 14,088 |
| medical insurance | 175,000 | 45,000 | 35,000 |
| total payroll cost | 1,890,486 | 547,785 | 521,970 |
| sales per direct labor employee | 200,000 | 333,333 | 142,857 |
| hours paid | 72,800 | 18,720 | 14,560 |
| hours worked | 64,400 | 16,560 | 12,880 |
| overtime hours worked | 9,620 | 2,405 | 1,801 |
| total hours worked | 74,020 | 18,965 | 14,681 |
| average cost per hour worked | 25.54 | 28.88 | 35.55 |
illustration: calculation of billing rate multiple for a professional service business and billings and revenue per employee
following are two models for a professional service firm that bills by the hour. here are models where the hourly rate is set at 2.5 and 2.0 times the payroll costs. note that payroll costs include all the added taxes, insurance and benefits.
| professional services business | (1) | (2) |
| direct labor costs – all inclusive | 1,000,000 | 1,000,000 |
| total all other costs | 666,667 | 666,667 |
| nondeductible cash disbursement items | ||
| capital expenditures | 83,333 | 10,000 |
| debt repayments | 125,000 | 0 |
| expected, anticipated or hoped-for profit | 250,000 | 25,000 |
| total revenues needed | 2,125,000 | 1,701,667 |
| assume billing rates and billed amounts are discounted 15%, i.e., realization is 85% | 375,000 | 300,294 |
| total to be billed | 2,500,000 | 2,001,961 |
| multiple of labor costs to be billed | 2.50 | 2.00 |
| assume average cost per hour | 100 | 100 |
| average billing rate | 250 | 200.20 |
| # hours needed to achieve gross billings | 10,000 | 10,000 |
| average work or chargeable hours per person | 1,600 | 1,600 |
| # of production people needed | 6.25 | 6.25 |
| billings per direct labor person | 400,000 | 320,314 |
| revenue per direct labor person | 340,000 | 272,267 |
| revenue per employee – assume one other person for every three direct labor people | 2.08 | 2.08 |
| total employees | 8.33 | 8.33 |
| billings per employee | 300,000 | 240,235 |
| revenue per employee | 255,000 | 204,200 |
a key number is the revenue per direct labor employee and revenue per total company employees. it is helpful in measuring changes in a company, and against similar companies.
for comparing accounting firms, i look at this number as a measure of efficiency, management and profitability. the greater the revenues, the better run the firm is and the higher the profits. for publicly held companies, i compare the revenues per employee for competitive companies to obtain a grasp of the company and its potential for continuing and future sustainable profits.
i believe every form 10-k shows the total number of employees somewhere. the total headcount does not include breakdowns by division, function or type of work done. in private companies, this information is readily available and should be obtained.
illustration: overhead cost allocation
there are many ways overhead could be allocated. for starters, the overhead items need to be identified and collected together. once there is a total, a method of allocating it to the product needs to be developed.
following is a summary of the overhead cost information and the allocation based on payroll costs:
| dept. | payroll | payroll taxes and fringes (30% avg.) | total payroll costs | other overhead costs | total | % used for overhead allocation | overhead allocated | total payroll and overhead | total hours | cost per hour including overhead |
| overhead | 2,600,000 | 780,000 | 3,380,000 | 4,000,000 | 7,380,000 | |||||
| dept a | 4,000,000 | 1,200,000 | 5,200,000 | 5,200,000 | 48.19% | 3,556,627 | 8,756,627 | 222,500 | 39.36 | |
| dept b | 2,200,000 | 660,000 | 2,860,000 | 2,860,000 | 26.51% | 1,956,145 | 4,816,145 | 175,000 | 27.52 | |
| dept c | 800,000 | 240,000 | 1,040,000 | 1,040,000 | 9.64% | 711,325 | 1,751,325 | 32,500 | 53.89 | |
| shipping | 1,300,000 | 390,000 | 1,690,000 | 1,690,000 | 15.66% | 1,155,904 | 2,845,904 | 89,700 | 31.73 | |
| total | 10,900,000 | 3,270,000 | 14,170,000 | 4,000,000 | 18,170,000 | 100.00% | 7,380,000 | 18,170,000 | 519,700 | 34.96 |
this illustration uses the dollar amount of labor to allocate overhead. there are other ways, and depending upon the circumstances, management needs to determine what they feel will yield the best results for their purposes. other methods of allocating overhead can be based on labor or machine hours, dollar value, units or pounds of raw materials put into production or consumed, or units produced.