Essential and Nonessential Overhead Cost
Some overhead cost is unavoidable; think building rent, insurance costs, and utilities. These are a natural part of operating a business. So are payroll service fees and income tax return preparation costs to keep firms in compliance. This is all “essential” overhead that is somewhat immutable in profitability assessments though it should be carefully managed and limited to what the company really needs.
Of course, not all overhead is essential. This is the first challenge that firms face in their overhead calculations: understanding what overhead is essential to profitability and contributes the most ROI for the business. For example, it might seem necessary to find a nice office location that draws in clients, but real estate is expensive. Unless the quality of the office can be justified by the increased clientele it brings in and the price clients will pay, these types of luxuries can significantly detract from profitability.
When assessing overhead items, a good question to ask is how that item directly supports revenue and client service. If the item were to be eliminated or reduced, how much revenue would be lost? Even items like rent are increasingly being questioned in today’s technology age where employees are increasingly able to work from home part of the time.
Overhead rates can vary significantly from firm to firm, and industry to industry. However, a quick analysis of gross profit margins and desired levels of profitability can help a firm determine what it should target for its overhead rate.
Overhead Cost in Talent Management
Managing overhead cost is all about looking at which expenses are tied to profitability. This applies to essential elements like rent, but it also applies to internal processes and employee management. For example, if a firm hires enough employees, it will eventually need managers to direct and support this staff efficiently. If this manager helps the firm grow its revenue and yield more profit (after subtracting the cost of the manager!), the manager was a good investment. The employee’s contribution can be directly tied to ROI. Conversely, if the firm hires a manager and the company doesn’t grow, the manager’s costs could be considered unnecessary overhead.
In other words, if an expense can’t be justified with increases in revenue, efficiency, lower costs, and ultimately higher profit, it runs the risk of being an unnecessary expenditure that detracts from a company’s profitability. By some estimates, these administrative roles should take up no more than 15 to 25 percent of the firm’s total headcount.
Balancing Overhead Cost and Utilization Rates
While employee costs, payroll, and benefits can be considered overhead, they’re generally non-controllable “pull-along” costs that comes with the territory of hiring good people. This is a tricky area to optimize; unless the firm leverages offshore services, contractor work, or part-time employees, there’s not much headway that can be made, here. Generally speaking, firms should recognize these costs but focus their optimizations on areas they can affect with more impact.
A good area for firms to prioritize here is utilization rates. When a firm gets big enough, there tend to be plenty of roles that are important to the company yet remain non-billable by nature. One example is a client account manager that organizes internal workflows and supports client service needs but doesn’t directly perform client work. In these cases, the name of the game is efficiency. The more effective the systems and processes are, the greater the number of clients/projects that these roles can support. Firms should spread these non-billable roles across as many clients and employees as possible; the more of these non-billable roles a company has, the bigger risk that profitability will suffer.
To keep tabs on profitability, firms need to account for each of these semi-utilized roles. Total overhead can be calculated by comparing the aggregate of billable time against the non-billable time in the organization; as utilization targets decrease and overhead increases, the firm loses profitability.
Watch Out for Unexpected Costs
Another point of profitability to keep in mind are the “hidden” types of overhead costs that are hard to predict. Non-billable creep is a great example, occurring when non-billable employee tasks increase in scope to the point where the employee’s utilizations targets decrease.
For example, a project manager, who is a billable employee, may be responsible for checking in with clients each year to receive status reports. As the company grows, this manager has more and more clients to contact, to the point where the manager spends hours each week performing these non-billable check-in calls. What began as a simple task balloons out into a significant (though still important) expense.
Similarly, firms may find that they have several high maintenance clients who consume disproportionate amounts of non-billable service hours by way of frequent communication or problem resolution. While these communications are important, they represent non-billable hours that detract from profits. Such frictional costs ideally are eliminated through more effective client service, though if that is not possible they might be offset with higher pricing for those clients.
Manage Overhead Cost Alongside Other Metrics
When times are tight, firms often believe that overhead optimizations are the best way to improve profitability. And for some firms, they are. But overhead is a metric that’s closely joined with service pricing and talent utilization; as such, it needs to be assessed alongside these other metrics before changes should be made.
Interested in learning more about how to optimize profitability for your organization? Download our free ebook The Four Levers of Profitability for Professional Service Firms.