I was bound for Europe for the first time. Hard to imagine that a full half-century ago I was old enough to travel on my own. In my senior year of college, I was managing a small travel business (even harder to imagine) with some operations in London and Paris, so I spent three summer weeks between the two cities monitoring activities there.
In an effort to be mistaken for a businessman, I packed accordingly – suit coats, dress pants, pressed shirts, ties, shoes, with multiple back-ups for contingency as I crossed the Channel seven times in twenty-four days.
In those days before comfortable back-packs and roll-on luggage, I opted for a canvass-sided suitcase, about 40″ x 24″ x 10,” and packed it full, including my office files. “Twenty-two kilos,” they told me when I checked it. Twenty-two tons is what it felt like after I’d lugged it through the London Underground to the remote hotel where I’d decided to stay in order to save money. And that was just the beginning for The Beast and me.
It was all overkill. The folks that I was working with couldn’t have cared less – probably didn’t even notice – that I showed up in a different business outfit every day. After all, working for BOAC (now B.A.) and Air France, they were in uniform, same thing day in and day out. But I had to be taken seriously, so the initial appearance – but only the initial appearance – was important. The rest of my baggage was just ballast. The Beast was my burden.
The baggage metaphor occurred to me a few days ago as I dug through a product/service-cost analysis for a well-established client. The management team and the sales staff has consistently complained to the controller that the pricing model is too heavy, that the standard cost threatens to price the company out of the market, and that she must be trying to stuff too much into the model. So we began to unbundle it.
The direct material costs of the products were easy to identify from the updated bill of materials, and the upward trend lines in vendors’ prices were as anticipated. But, surprisingly, even though the company hasn’t had a general pay increase for two years, the direct payroll costs have also increased. (Direct payroll is defined here as covering people who make and/or deliver the product or service.) As we unpacked the baggage, this is what we discovered about the direct payroll:
- The staffing level (FTEs) in 2012 increased roughly proportionate to the increase in sales vs. 2011.
- The use of overtime increased at a greater rate than sales.
- Benefits costs per employee increased 12%.
- Paid time off per person increased by almost 10% due to the addition of one holiday in 2012 vs. 2011 plus increased vacation time as employees achieved longer tenure.
To weigh the implications of this (stay with me here – these numbers are really fairly easy to understand), we started with
- Average hourly wage of the direct payroll people: $20.00
- Annual number of hours available to work (52 weeks x 40 hours): 2,080
- Average annual straight-time gross compensation (A x B): $41,600
- Employer-paid payroll taxes (including FICA, SUTA/FUTA) and worker’s compensation premium totaling 10%: $4,160
- Employer’s share of health insurance expense, average at $750/mo.: $9,000
- Note: Health insurance alone adds $4.33/hr. to cost of the employee (E/B)
- Paid time off, average 20 days vacation/holiday/sick (160 hrs./2080): 7.7%
- Efficiency (allowing for set-up time, breaks, meetings, training, rework, etc.): 75%
And we then calculated:
- Annual gross pay [as in C above]: $41,600
- Add payroll taxes [C + D]: $45,760
- Add benefits [I + E]: $54,760 (total out-of-pocket expense)
- Add allowance for paid time off: 160 hours
- Allow for inefficiencies: 520 hours
- Total Billable Hours [B-K-L]: 1440
- Loaded payroll rate [J/M]: $38.03
Having accounted for all of the baggage in our standard cost model, we concluded that in order to cover just the straight-time cost of a single 40-hour employee, the company needed to recover $38.03 for each billable hour. Payroll burden thus added $18.03/hr. (90%) to the employee’s base pay. Even as I packed my suitcase for Europe without thinking about what I was adding to my burden, so was the company failing to realize what it was adding to its costs with each supplement to the benefits package and the PTO, coupled with the inefficiencies in its daily operations. In each of these areas, we have resolved to tighten up in 2013.
But this is only half the story. My client, like businesses everywhere, also has to recoup its overhead burden for Selling, General and Administrative (SG&A) expenses. (Other companies may also have Research and Development costs to offset.) Historically, a rule of thumb is to apply a 3x factor – three times the fully-loaded direct payroll cost – to cover SG&A expense (33%) plus owner’s compensation, profit, and taxes (33%) when determining selling price. Applying that formula to this example yields a price per labor hour of $114, which is close to the top end of what the market will bear. Clearly, additional work is needed on the company’s economic model and on the budget.
So before you go packing your payroll with additional employees in an effort to help reduce the national unemployment rate, take a deep breath. Think about having to lift and carry that burden and about paying for it. What’s the true cost of each of your people? Unpack your own baggage – bare your burden – and share it with your employees. It may help them appreciate just how much you have invested in them.