Overtime Reduces Production Costs
Many of my clients are concerned about managing overtime; they fear that the additional cost of labor will reduce the profitability of jobs run over extra shifts; often passing upcharges to their clients. I argue that these are the most profitable jobs they’ll run all week. I’ll tell you why.
Budget Hourly Rates are not Labor Rates
Most of the Printing and Packaging uses the BHR model to establish cost rates for equipment and support the “Cost Plus” method of price setting that dominates this business. Other methods exist, but (in my opinion) methods that focus on production payroll given the high levels of automation and productivity found in the modern plant.
Let’s look first at the components of a BHR, then we perform some quick calculations to make the case for the benefits of overtime.
- BHR = Budget / Productive Hours, where:
- Budget = Fixed Costs + Variable Costs
- Productive Hours = Planned Operating Hours – Downtime
There are two key points to take away from these simple equations:
- Fixed Costs are intended to be recovered in the Hours built into the rates.
- Productive Hours are typically much less than the 8,760 hours in a year.
When we run additional or extended shifts, our fixed costs should drop out of the equation, and the Productive Hours increases. Both of these changes counter act the increase in cost caused by time and a half or double time labor.
There is a lot of information and decision making contained in the calculation of a machine budget. I’ll save the details for a later post.
The short version is that the budget has four components in two dimensions.
- Fixed vs Variable: Fixed costs do not change whether a machine runs for one hour or one thousand hours. Variable costs are incurred whenever the machine is running (or staffed).
- Direct vs Indirect: Direct Costs include operator wages, electricity, and other elements needed to operate the machine. Indirect Costs are better known as “overheads” and are elements that support the operation of the machine.
Some examples of these:
- Variable Direct Costs: Wages and Payroll Taxes, Electricity, Supplies, (some Maintenance), etc.
- Fixed Direct Costs: Depreciation, Employee Benefits and Training, Rent, (some Maintenance), etc.
- Variable Indirect Costs: Hourly Supervisors, Helpers and Materials Handlers, etc.
- Fixed Indirect Costs: Front Office Space, Salaried Office, Insurance, etc.
Of these, only the variable costs are incurred when running an extra shift. Wages and Payroll taxes are incurred at a higher rate, but unless these make up 50% or more of the total budget they will be less than all four categories combined.
Few machines in our industry are able to run nonstop for an entire year. Even if the press can do it, it is likely that there will not be sufficient staff to cover all of those hours. Even when employees are on the clock, it is likely that they are not 100% productive.
Many factors reduce the availability of an employee. In a 40 hour shift. All US States mandate breaks during the workday. In my home state of Illinois, the rule is 20 minutes unpaid for a shift of 7 and half hours or more. In California, the rules are 10 minutes for every four hours plus 30 minutes when working more than 5 hours. Unless you have staff to cover operations during breaks it is likely that at least some of your work centers go down during some of these breaks.
Preventative maintenance should also be deducted. Of course there is “unplanned downtime”, to account for; unless you are very optimistic. Many environments are also impacted by holidays, meetings, weather, staffing shortages (sick days), company picnics, and other events.
All of these elements reduce the realistic planning number for productive hours by up to 20%. This means that a single shift may operate for only 1,700 hours in a year vs the 2,080 one expects from 52 x 40 hour weeks. In a 5 x 24 operation, this means one should expect roughly 5,100 Productive Hours.
The Impact of Overtime
To tell the truth, there are two ways to look at this. Only one of them can be true at the same time. We can either spread the Budget over a larger number of hours, or we reduce the hourly cost.
Both methods are reasonable, but the results are not the same. Let’s imagine the following:
- A press is staffed for three shifts, 5 days per week: 5,100 hours
- The Hourly Rate of the Press is $250 / hr, supporting an annual budget of $1,275,000.
- Variable Costs account for 35% of the total, so we call that $446,250
- Direct Labor Costs make up 50% of the Variable which is $223,125 ($43.75/hr)
Increasing Costs and Hours
Using the first method, we increase the total costs and the total hours to create a new hourly rate for the entire year.
Based on this model, our costs increase by $875 to $1,275,875 and our hours increase to 5,108 so our new hourly rate is $249.78. The $0.22 is small, but multiplied back into our 5,108 hours it means that we save $1,123.24.
If each of our 3 shifts work 1 extra day per month, the annual savings increases to $38,335.19
Incremental Costs and Static Hours
If we calculate a new hourly rate for our overtime hours, we take our $875 in incremental costs and divide it into the additional 8 hours resulting an hourly rate of $109.38, an hourly savings of $140.63 and a one time savings of $1,125.
Extending this model to 3 overtime shifts per month for the year, we calculate $40,500 in savings.
The Preferred Model
The second method is a little easier to envision; multiply the revised costs rate by the hours worked and we see the marginal cost of the extra hours. This machine time is clearly less expensive and it is likely that this job is the most profitable job of the week.
The first method more accurately describes what we expect to see in the accounting system. If our general ledger is correctly structured, we should see an “over absorption” or an increase in “profits” in a manufacturing P&L.
The results differ slightly between the two methods. It is likely that reality is somewhat different, but the direction of the results is clear: Incremental Overtime is Profitable even when selling costs remain the same.
There are Limits
Occasional overtime is clearly profitable. That doesn’t mean that the gains are limitless. At some point, it becomes less costly to hire more workers and add another shift.
Several factors influence the potential savings from overtime.
- Increases in the labor portion of the BHR decrease the savings.
- Increases in the planned productive hours decrease the savings, i.e. the hourly savings from overtime on a work center with 2 shifts are greater than the savings for a work center with 3 shifts.
- Increases in the Overtime multiplier (i.e. time-and-a-half to double-time) decrease the savings.
- Employees may burn out with too much overtime and become less productive, however the pay associated with occasional overtime will likely be considered a bonus.
This exercise shows us that overtime should not be feared. It can be more profitable to run a job in overtime that it would be to run it in regular time. The savings from overtime operations may not be visible in your job cost analysis, but you should expect to see a favorable gain in overhead absorption on your manufacturing P&L.
It is also important to remember that it is not necessarily the job run over the weekend that is the cause of overtime. Instead, the lack of capacity during the week prevented the running of the job during the standard shifts.
Steve Rice is the Director of Business Consulting at EFI. Educated as an economist, he has worked in technology and consulting for more than 20 years at a major consulting firm, with Fortune 500 companies to small businesses. He has spent the last 10 years with EFI focused on printing and packaging, working with clients in multiple industries around the world. He can be contacted at firstname.lastname@example.org.