GPI 363 – To monitor adequacy of price increases, measure your absorption dollars as a % of net sales.

When you buy a piece of equipment for a business, you must determine a fully absorbed overhead rate to use in order to reflect all of your indirect overhead used in production.  Direct labor, material and outside services purchased for the job are known and easily identified.  Overhead rates are not understood by most and sadly underestimated when quoting prices. In high capital industries, overhead rates run 200-300% of labor costs so it is wise to take the time to calculate them often.

Overhead rates attempt to allocate all indirect costs. This dollar per hour rate for each machine includes costs for quality control, shipping, receiving personnel, indirect supervisors and production office clerks, planning personnel, depreciation, property taxes, electricity, gas, water and sewer charges and any other manufacturing support charges that are unique to your business.

Choose your base denominator for allocating costs to fit your company. Since these costs are incurred through a defined time period, they must be divided by some applicable base number appropriate for that same period. You can use budgeted machine hours (one man, one machine) or labor hours (multiple heads or teams used) or some other denominator that is applicable to your business. Select or decide upon a base that fits the needs of your firm.

Rates stay constant over a period of time. Whatever you decide should remain constant for each machine, work center or other work group through your budget period. This rate will stay in effect for several months or quarters until costs change materially. Each month after closing your financial statements, compare actual costs to the allocated overhead you used. See if actual costs exceeds your calculated applied rate and act accordingly. Once costs exceed your applied rate, you will recalculate all of these costs and re-budget expected direct labor or machine hours that will be used.  This can be done quarterly, every six months or annually.

Sales dollars per hour represent a payback of your capital investment.   When you add all of the dollars per hour for overhead, you have absorption for the day, week or month.  A good comparison to do at that point is how much more sales is versus absorption.  Hopefully it is a lot more.

Measure absorption as a percentage of sales to see erosion or improvement of profit.  One way to measure if your sales dollar return or rate is improving or worsening is to divide total monthly absorption into sales dollars. Calculate this monthly.  If the percentage is rising, your sales dollar markup is getting worse (costs rising as percentage of revenue).  If the percentage is decreasing, your sales dollar markup is improving (costs decreasing as a percentage of revenue).  This chart is only appropriate as measured over time.   Try going back and retrieving the prior quarter, six months or one full year to see the pricing trend.  This will tell you if you are getting enough sales when quoting out your machine time.