Organizational Productivity Part 50: Understanding Managing Overtime

Many organizations believe that increasing direct labor hours reduces overhead. In reality, increasing direct labor hours increases direct labor cost and has no effect on overhead.

“Any company run by unknowing and mechanistic minds is in jeopardy and faces a limited life. Specifically, the pursuance of policies that focus on cost reduction and a continued optimization of the bottom line just accelerate progress towards sudden death.” – Peter Cochrane

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In today's session, we're going to continue on the path of mindset change necessary to achieve breakthrough performance in a company, and this session today is about managing overtime. The belief that I've seen in companies is running overtime to increase direct labor hours work reduces the overall overhead of the company. So I want to challenge that mindset and recalibrate our mindset around what it should be.

First of all, let's talk about margins. A lot of companies talk about different types of margins. I've heard variable margin, I've heard direct factory margin. I've heard product margins. So what are the different margins? So, first of all, factory direct margin is our sales revenue minus our direct factory cost divided by our sales revenue. Variable margin is just the selling price minus the variable costs. Variable margin ratio is the sales price minus those variable costs divided by the sales revenue. And then our product margin is our selling price minus our total cost. Our total costs are a sum of our fixed costs and our variable cost.

So let's take an example to explain this week's scenario. So if I have fixed factory overhead of $1000 a week, my direct labor hours worked is 40 hours. My fixed factory overhead per labor hour then is I take the $1000 divided by the 40 hours work and I get an overhead of $25 per hour. Now, if I work overtime of 10 hours, my factory direct overhead doesn't change, it's still $1000, but I've added 10 hours of labor, so now my direct labor hour per fixed overhead goes to $20, because I've added more to the denominator and made it 50. The 10 hours of overtime absorbed more cost; therefore, the fixed overhead that's allocated to each unit produced is reduced from $25 to $20. So in this case, when we allocate the overhead, the amount of cost that we allocate goes down.

Let's look at it from a perspective in this table. We have product A takes us 20 standard direct labor hours to produce that product. We can produce 500 units in the 40 hours. So now how much overhead do I allocate to those products? I take the $25 times the $20 because that's my factory overhead per hour, divided by the 500 hours I've worked and I allocate $1 of fixed overhead to that product. Now, if I run overtime and I can warrant a Saturday and produce 100 more units on that extra day of work, where it takes me 10 hours to do that. Now my fixed overhead per labor hour work is $20. So I have the $20 times the $20 of direct labor units to produce a unit divided by the 600 units produced, now my fixed overhead goes to 67 cents. The effect that we're seeing is the fixed overhead allocation goes down.

So this is why people believe that if I run overtime, my fixed costs are reduced. No they're fixed costs so they don't change, they're fixed, but the belief is the margin or product A is increased because there's fixed costs allocated to that product. So, that's where the issue comes. But let's look at it from an impact on margin and profitability from a company perspective. So at my standard 40 hours, I get sales from those units, those 500 units that I produce of 5,000. My variable cost is at 35%, so I have 1750 in variable cost to produce those 500 units. My direct labor is $800. My fixed factory costs are $1000. So my margin in this case is my sales, my variable, my direct labor, my factory costs, so I have 1,450 in margin, which is 29%.

So now if I run overtime, my sales goes to 6,000, my variable costs go up at the additional units produced times the 35% to 2100, direct labor goes up to 1100 because I'm paying time and a half for my labor on Saturday, my fixed costs don't change. My margin goes from 1450 to 1800, which is a 30% margin. So I only gained one point of margin by running the overtime. Our approach is what happens if we could make the labor more productive, so if I could get 20% improvement in productivity of our labor, what happens? So now I get my improvement of $6,000 for the week. I don't run any overtime. So my variable costs still go up to 2100, but my direct labor stays at 800. My factory fixed costs are still 1000. My margin goes to 2100 or 35. So if I can make a 20% improvement, what's that worth to me? It's worth six points of margin where overtime only gives me 1% margin.