How to Get to the Bottom of Employee Profitability
In part one of this series designed to explain what it takes to truly understand your business, we outlined how to determine how much money your business is actually making. In part two, we explored ways to help you better understand your staffing costs.
Now that you have the relevant insights you need, how do you actually go about calculating contributions to your bottom line?
At first glance, the calculation for ‘Marginal Daily Cost’ looks quite simple. Each employee has a known salary and plans to work a set number of days or hours per year:
This number is a reasonable approximation of an individual’s direct, incremental or marginal cost per day. However, to calculate the fully loaded cost that should be used in profitability calculations, you need to take more items into account.
(Note the divisor in this equation is the Effective Working Days per full-time equivalent (FTE), generally between 220 and 230 days. It is referred to as such in the equations that follow.)
Method 1: Blended Cost Rate
To decide how to incorporate your overhead costs via your man-day cost, you first need to decide which of your revenue streams assume man-days as key overhead costs. For instance, you may decide that software license sales are not man-day dependent but the rest of the business (support and services streams) is.
So, to calculate the percentage of overheads that must be recovered via man-days:
The second key decision is which of your staff contribute to revenue. Normally, this would exclude management, sales and marketing, finance and administration staff, but include all others. We will call these people Delivery Stream Staff. The FTE value of this group takes into account part-time workers and any phased head count that your budget assumes during the year.
The final decision is whether you expect your contractors (who are, in effect, under cost of goods employment) to contribute to overhead recovery. This will depend on what percentage of your staff they represent. For this example, we will assume they don’t make a budgeted contribution to overhead recovery since they are a fully variable income stream.
With these assumptions, the fully loaded blended man-day cost is calculated as:
(Note: The total overhead budget here includes all salaries, burden and other non-sales related costs.)
Method 2: Fixed Overhead Recovery
The Blended Cost Rate method gets you a good working number and will ensure profitability calculations are at least meaningful. However, it doesn’t take into account individual salaries. If you have customers, projects or products that don’t conform to a normal mix of staff, the result can be misleading and may lead to bad decisions.
To improve the granularity, we need a new cost definition, which is the Annual Overhead Budget less the direct cost of the Delivery Stream Staff. We’ll call this cost group the Fixed Overhead Budget. So, the individual cost rate for the Fixed Overhead Recovery (FOR) method is calculated as:
This will give you a personal cost rate, but it may be too much detail and/or too much maintenance. A common middle road is to group staff into “cost bands” in the same way you may group them into charge bands. Replacing the marginal daily cost with group averages in the equation above will get you very accurate profitability numbers and eliminate the possibility of someone reverse-engineering salaries from cost reports.
Method 3: Variable Overhead Recovery
Fixed Overhead Recovery, especially by bands, is accurate, practical and meaningful, but some would argue that …