Need Help? Give us a call.
1 (800) 386-3372
Your business’s financial statements are a lot like a full medical report. They can tell you exactly how healthy your business is while also highlighting areas of potential concern. Simple adjustments early on can help you avoid serious complications down the road.
At first glance, a full medical report might lead you to a certain conclusion about your health. Usually, a deeper analysis is needed in order to get the full meaning of the report, though. Variables often exist that can impact your overall health, and these variables aren’t always immediately obvious.
Just like a full medical report can give you an overview of your health, your profit and loss statement can tell you how your business is performing at a glance. In particular, your profit and loss statement highlights your direct costs and indirect costs.
Direct costs are the costs that go directly into the production or delivery of your product or service. These costs are typically categorized as cost of goods sold (COGS) and appear right under your income to show you your gross profit. Indirect costs—or overhead costs—on the other hand, are the costs that go into running your business. They are subtracted from your gross profit in order to show you your net profit, or bottom line.
This all seems pretty straightforward. There is a hidden variable here, though, and it’s one that can be confusing to a lot of business owners. That variable is the impact your indirect costs have on your direct costs.
This variable is called burden rate.
Burden rate is the rate at which indirect costs are allocated to direct costs to give a truer picture of the cost of producing or delivering a product or service.
This concept is easier to explain with an example of how burden rate impacts your labor costs.
Let’s say you own an advertising agency. You have graphic designers and copywriters on staff, and these employees’ time is billable to your clients. As such, you report their billable wages as COGS. When you review your profit and loss statement, you will see their billable wages subtracted from total income to show your gross profit. This is important information, because you can tell at a glance if the services you deliver are profitable, at least from a high level.
However, there are other expenses that go into having employees. These expenses—which aren’t billable to your clients—at a minimum include payroll taxes and workers compensation insurance. Depending on your benefits plan structure, they may also include health insurance, retirement plan matching, travel allowances, and fringe benefits like cell phone allowances, among other expenses.
These additional expenses are added together to arrive at your labor burden cost, or the cost of employing your staff above and beyond wages. Labor burden cost is divided by wage costs to arrive at your burden rate.
Burden rate doesn’t only apply to labor, though. In manufacturing, burden is applied to inventory to arrive at the actual cost of producing an item. This is often referred to as factory or manufacturing overhead, and it can include labor, machine hours, and other overhead costs that indirectly impact the cost of manufacturing products for sale.
Burden rate is easy to calculate once you determine what should be included in the burden cost number.
Going back to our example of an advertising agency, let’s say your graphic designers are paid $60,000/year and your copywriters are paid $64,000/year. Annual taxes, insurance, and benefits per employee are calculated at $15,000 per year for graphic designers and $17,000 per year for copywriters.
The labor burden rate for your graphic designers is:
Labor burden / Payroll cost = Labor burden rate
$15,000 / $60,000 = $0.25
And for your copywriters, the labor burden rate is:
$17,000 / $64,000 = $0.27
This means for every dollar you spend on wages, you incur $0.25 in overhead costs for your graphic designers and $0.27 in overhead costs for your copywriters.
Inventory burden rate is very similar to labor burden rate. Instead of focusing only on additional labor costs, though, inventory burden rate can also be calculated by activity measure.
For example, let’s say you own a factory that manufactures whatsits. The machine you use to manufacture these whatsits costs $1,000/month to keep in service. Each whatsit takes 1 hour to manufacture. Finally, your machine is in service 160 hours per month.
Your manufacturing overhead cost in this simple example is $1,000. We divide this number by the activity measure of 160 hours to come up with our inventory burden:
Overhead cost / Activity = Inventory burden rate
$1,000 / 160 = $6.25
So, for every hour your whatsit machine is in use, you will add $6.25 to the direct costs of producing your whatsits to arrive at your fully burdened inventory cost. Since it takes 1 hour to make a whatsit, you will add $6.25 to the cost of each whatsit to arrive at the true cost of your completed inventory.
Sometimes, a business will include other indirect costs in calculating their burden rates. These costs can include rent, breakroom supplies, IT costs, and other overhead costs. If you choose to include other indirect costs in your burden rate calculations, you must be careful to only include those costs that actually apply to your business situation.
For example, if your rent expenses are directly impacted by the number of workers you have—as might be the case if your office is in a coworking space that rents by the desk—then including rent expense in your burden calculation would make sense. If, on the other hand, your rent wouldn’t change by adding or reducing your number of employees, then you might not want to include rent in your burden calculation.
Many business owners use their fully burdened costs to make decisions about how to operate their business. This is why it’s so important to only include indirect costs in your burden calculation that apply to your particular business situation. Otherwise, you might make an unwise decision about your labor force or production strategy.
Going back to our advertising agency one more time, if we were to outsource the copywriting position in our advertising agency for the same amount we pay our in-house copywriters—$64,000/year—we would save $17,000 per year in indirect costs. Or maybe we don’t want to outsource this position, but instead we want to consider bringing on an additional part-time copywriter. We now know the full cost for employing the copywriter will be around $0.27/hour in addition to their hourly rate.
Similarly, we might decide an additional $6.25 per whatsit is more than we want to pay to produce whatsits in our own factory. If a fully burdened whatsit costs $19.25—$13 in direct costs plus $6.25 in indirect costs—but we find a factory that will produce whatsits for us for $15.25 per whatsit, we might decide to sell our whatsit-making machine, outsource the production of whatsits, and instead focus on producing something else in our factory that will cost us less per hour to manufacture.
Burden rate and fully burdened costs typically won’t be reflected on a small business’s financial statements. Knowing your burden rate and fully burdened costs can help you make sound managerial decisions about your business, though. Especially if your business has highly variable indirect costs, analyzing your fully burdened labor or inventory costs will help you see how even minor changes in your business’s operations can help you realize more profitability.
The most difficult part of calculating burden rate is deciding what to include in the burden cost calculation. Simplicity is key here. Although you could argue that all indirect costs somehow tie back to the production or delivery of a product or service, overcomplicating the calculation will only make it more difficult to wisely use the burden rate information for your business.
Finally, just like there is more to health than keeping your weight in check, there is more to running a profitable business than keeping costs low. Burden rate is one of many tools you can use to analyze the cost of doing business and steer your business toward deliberate profitability, but it shouldn’t be your main determining factor when making business decisions. Whether you are considering bringing on more labor or outsourcing production, it’s important to keep in mind the intangible benefits and risks of these business decisions. Sometimes, keeping expenses low has an unintended negative impact on your business as a whole.
Now that you know more about the hidden variable that is burden rate, you are better equipped to make more informed business decisions. As always, if you have questions about how burden rate impacts your business’s particular situation, consult with your accountant.