April 16, 2020
Whether a company is growing fast or there is a rapid contraction in demand, employees will feel distress. To manage through these difficult times, it is crucial to minimize the negative financial and human aspects of change. In this report, we focus on the financial aspects in periods of crisis. When management teams base decisions on preconceived notions of labor costs, including overtime, they make incorrect decisions. The three most common errors are:
1. PEAK DEMAND STAFFING:
Management teams can staff for peak demand and have enough labor to complete work on short notice. However, incremental full-time employees, when evaluated at a fully burdened cost, are expensive.
2. OVERSTAFFING TO MINIMIZE OVERTIME:
The long-held believe that overtime is expensive ignores that overstaffing, or having idle time, is far more costly than using overtime to address periods of high demand. Overstaffing to minimize overtime makes contraction expensive and has a negative impact on employee morale when layoffs become a reality. Job insecurity and partial paychecks exacerbate these feelings among the workforce.
3. DISREGARDING CUSTOMER SERVICE AS A PRIORITY:
Product companies can elect to produce at a steady pace and sell out of items when volumes cannot meet customer demand. This approach is risky in today’s on-demand world, where under less than the most extreme circumstances, customers do not tolerate shortages. In professional services enterprises a lack of qualified personnel results in lost opportunity.
THE STRATEGIC USE OF OVERTIME:
Overtime, within reasonable limits, is a means to meet variable and seasonal demand. Companies carry the headcount they need during low-volume periods and flex with overtime hours to meet peaks in customer demand. Because employees are in place, trained, and benefits are already paid in the first 40 hours (i.e., assuming 100 percent absorption of those hours), the incremental or adverse costs associated with this strategy are low.
BREAKING DOWN LABOR COSTS:
Labor costs must be broken down into three key components to fully understand how they work during different modes of operation. An accurate understanding of these costs allows management teams to make profitable decisions.
This is the base wage, not including benefits, typically paid to a group of employees. The average wage should be considered based on each department group. Temporary, part-time, and seasonal employees should also be considered.
FRINGE BENEFITS (BURDEN):
These benefits are typically fixed costs, including medical insurance, 401(k) plans, and dental plans, to name a few. Other items such as FICA, FUTA, and SUTA should also be included. They should be expressed as a percentage of the average wage.
This ratio represents the total hours an employer pays an employee over the course of a year divided by the hours the person works. This calculation incorporates costs including vacations, holidays, and other paid time off.
Once you have identified the average wage, fringe percentage, and pay ratio, the three numbers are multiplied to return the fully loaded cost of one labor hour of straight time. For overtime, the numbers change. We assume full absorption of labor during the first 40 hours. Starting with the 41st hour, various costs are not applicable because they are fixed and covered in the first 40 hours. These costs include the burden associated with fringe benefits. Although health benefits are a fixed cost, taxes must always be paid on overtime, and some retirement benefits are often included as well.
HERE IS AN EXAMPLE OF SOME TYPICAL NUMBERS:
Average Wage = $15.00
Burden = 35%
Pay Ratio = 15%
Overtime Burden = 10%
Overtime Penalty = 50%
Cost of Straight Time = $15.00 * 1.35 * 1.15 = $23.29
Cost of Overtime = $15.00 * 1.5 * 1.1 = $24.75
Adverse Cost of Straight Time = $23.29 – $23.29 = $0.00
Adverse Cost of Idle Time = $23.29
Adverse Cost of Overtime = $24.75 – $23.29 = $1.46
Considering the difference between the non-value-added cost impact of idle time (i.e., $23.29) in comparison to overtime (i.e., $1.46), making the wrong decision to overstaff, or underutilizing employees during the workday, can be very expensive. Idle time is 16 times more expensive than overtime.
Think about how staffing can drive the low-cost solution while considering the chart below.
This data comes from a food processor with 455 employees. The chart shows the extreme choices they can make to avoid either overtime or idle time. Their current staffing strategy is to staff to the peak (455 employees or 18,200 hours). They have seasonal and variable demand and accurate forecasting is difficult.
They cannot miss shipments and staffing to the peak is their insurance policy that work will be completed. To understand the financial impact of this strategy, we must refer to the true labor costs associated with being either understaffed or overstaffed.
The lowest-cost solution represents the line where the plant is understaffed approximately 16 times more often than it is overstaffed, reflecting our difference in adverse costs, in this case, avoiding $3,139,500 in additional labor costs. This finding highlights the need to take a fresh look at strategic overtime usage and demonstrates that idle time should be the main focus for labor cost reduction.
Do not be fooled. The argument against excessive overtime is most logical when it relates to unnecessary overtime due to idle base hours; that is, the first 40 hours of work are not absorbed by productive activity. For example, unplanned maintenance downtime, material shortages, and quality issues can trigger overtime. In these cases, where demand is not the driving factor, the lack of operational effectiveness is aggravating costs. This condition should not be confused with overstaffing to manage seasonal or variable demand fluctuation. Overtime is an effective tool, assuming employees are effective during the first 40 hours paid.
WHAT IS THE OVERTIME LIE?
The overtime lie is what we have all been told and assume to be true: “Overtime is more expensive” and, if we “keep overtime below 5 percent” it means we are doing well. This is bad advice when we examine the facts. The fear of overtime has forced management teams to over-staff and overstock. Warehouses must shoulder the cost of inflated inventory levels to handle last-minute spikes in volume.
The effective use of overtime can create flexibility in a plant when done correctly. Inventory levels can be kept low while not affecting customer service by creating a more on-demand environment. Overtime-savvy management teams can implement labor strategies that allow additional production to be completed on short notice. The workforce can flex to handle these spikes, and product can be made on-demand and delivered just-in-time. This approach results in better customer service and lower inventory levels, giving your company the ability to compete more effectively.
Instead of overtime being a bad thing, it becomes an effective business tool that will help you achieve your goals. Overtime can translate into lower prices and shorter lead times.
HOW MUCH IS TOO MUCH?
Health and safety factors limit the amount of overtime an employee can work. Once management teams grasp the reality of the cost, it is possible for them to become too aggressive with the use of overtime. Experts agree that over an extended period, employees should limit the time they work each week to no more than 53 hours. Employee appetite for additional work hours may exist, but it is crucial to balance employee preferences with healthy boundaries.
Companies with seasonal or variable demand often have difficulty predicting the necessary labor capacity. The caution is that management teams can run too lean and end up unable to satisfy their peak period requirements. Although they are in the low-cost position, if too aggressive, they can impair customer service. Conversely, if management teams believe that high demand spikes are going to occur, and those spikes do not materialize, they end up with excess cost. Accurate forecasting is difficult, and well-advised management teams proceed cautiously.
WHAT DOES THIS MEAN FOR YOU?
Decisions based on a small set of business realities result in unintended consequences. Labor strategies, including staffing levels and overtime usage, must be evaluated based on several modes of operation. When an organization faces crisis, it is often too late to make improvements, especially in periods of volatility.