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11 Jun 2012 07:36 GMT • 5 responses
OVERTIME CAN BE CHEAPER THAN NORMAL TIME ... USING PAYROLL BURDEN CONCEPT
In all our Unit Rate contracts, we have provision for Normal Time and Overtime Rates, Further, in many such contracts, there are even different types of overtime rates for weekdays and weekend / public holiday. These overtime rates can go as high as twice the normal time rate. Have we ever questioned ourselves as to why as clients, we are accepting so much higher overtime time rates? What would be your instant reaction if I start by saying that “OVERTIME RATE SHOULD BE ACTUALLY LOWER THAN THE NORMAL TIME RATE!” I guess, most readers will call it insane, some smart clients might get curious, and all contractor organizations will feel highly offended. However, before we make any judgment on this potentially sensitive and thought provoking topic, let us go back to the “first principles of costing”, a concept I always use when I have any doubts on commercial aspects.
Let us look at the concept of invoicing using Payroll Burden percentage in reimbursable contracts. Payroll Burden for overtime is generally very low or 0.00% is many cases. This means all or most of the Payroll Burden is recovered over Base Hours. Hence the overtime rate is solely depended on company policy or statutory requirements, which determines whether overtime payment to an employee is made on a straight time or at some Overtime Premium such as 1.25 or 1.50 on the straight time, which when combined with much lower or 0.00% Payroll Burden for overtime, may lead to an overtime rate which can be even lower than the normal time rate. Further, the overtime rate can even be lower, if company is recovering most of their Corporate Overheads on the Base Hours.
This is not academic at all, and happens in the real world. As an example, in one of our long-term maintenance contracts, which is a reimbursable contract where invoice rate of the contractor personnel is based on actual salary and payroll burden, the overtime rate is actually much lower than the normal time rate.
For those of us who are not so much familiar with the concept of Payroll Burden, let me provide a brief overview. The Billable Rate to a client for a contractor’s personnel is a function of 5 things: i) Basis Salary ii) Payroll Burden iii) Corporate Overheads, iv) Profit, and v) Base Hours. The Billable Rate is generally computed for an annual basis, and most Payroll Burden elements are generally recovered over annual Base Hours. Payroll Burden covers all employee benefits and unavailable time, and is computed over recoverable hours to ensure full recovery of payroll burden over recoverable hours. In contractor organization, there could be several payroll burdens for different categories of employees grouped with similar payroll benefits, and also varies depending on employee origin, marital status, work location etc. The Corporate Overheads cover fixed and variable costs of operating Contractor’s business, which are not explicitly reimbursable in nature. The Corporate Overheads are also generally recovered over Base Hours, but there may be some elements of Corporate Overheads which may still be applicable on overtime hours worked. Base Hours are the total work hours including absences, as later is already included in the Payroll Burden. The Billable Rate is a total of Base Rate, Overtime Premium, Payroll Burden, Corporate Overhead and Profit, where Base Rate is computed by dividing Basic Salary with Base Hours.
This fundamental of costing is explained using reimbursable contracts as an example. But the cost is what the cost is. If overtime rates under reimbursable contracts are cheaper, then there is no reason for these to higher for the Time Rate / Unit Rate contracts. A company might have to pay a premium (1.25 or 1.50 times) to its employees on their “Base Rate”, but in the Unit Rate contracts, a much higher premium (up to 2.00) gets applied on the overall Unit Rate, which is actually made up of several components as explained earlier. This means from the perspective of costing, such a premium on Unit Rate is actually getting applied on all elements of Billable Rate such as on Payroll Burden, Corporate Overheads and Profit, where in actual fact, the Payroll Burden and Corporate Overheads should be much lower for the overtime hours, and a company should not be making a premium on the Profit earned on the overtime hours.
So when we develop our Unit Rate contracts, especially big OEM contracts, we can use this information to understand the composition of a much higher proposed Overtime Rate. Not much literature seems to be available on this sensitive topic, and it is really worthwhile to explore further. Appreciate any thoughts on the subject and links to resources!
Edward Willey III
12 Jun 2012 10:52 GMT
In one sense, a much higher overtime rate acts an incentive for the buyer to work carefully with the seller to manage labor resources efficiently.
I understand your point from a mathematical perspective, but I suspect that most sellers are going to resist reducing the overtime rate based on this theory because they do not want to do anything to disclose the value of the components of the billable rate. The position I normally take in negotiations (for seller) is that a detailed analysis of the components of a billable rate is not particularly productive. Instead, I try to focus the discussion on the reasonableness of the billable rate based on market conditions.
16 Jun 2012 11:56 GMT
We are seeing more and more of this - that is, agreeing full visibility of the profit, overhead and fixed components of an hourly rate and then being able to use that visibility going forward in agreeing increases to rates, and of course overtime components. I wouldn’t say this was standard in our company (a major international oil and gas corporation), but it is becoming a recommended approach.
21 Jun 2012 07:16 GMT
While it is true that overtime can be cheaper than normal time that normally happens only in real boom times. The factor which makes such a counter intuitive rate possible is usually the fixed overhead. Normally a business will , at budget time , make a decision on how the fixed overheads in the business will be recovered and that “recovery” will be based on the number of manhours sold by the business. Again , in the usual course of things , many businesses will apply the fixed overhead to a mixture of normal time and overtime because , in most businesses , experience is that there will be peaks and troughs in demand and there will be periods in which overtime is worked and periods in which normal time is not fully sold so the budget has to be based on the likely pattern of sold manhour burn.
In the good times , and there have been some in my career , one sees Finance Directors leafing through BMW sales manuals , and in the bad times one sees them leafing through books on downsizing. In the good times one will usually find it possible to elicit the information that the business is “overrecoverring” its overheads. What that means is that the business has sold all the budgeted manhours and is now selling manhours at rates which include a portion for fixed overhead ; whereas the fixed overhead has already been recovered so that the portion of the rate allocated for fixed overhead is now running directly to the bottom line.
For those working on true cost reimbursable contracts an appreciation of the cost principles and the variables is key to the ability to assess cost and to differentiate cost from rate. Making sure you understand the contractor’s true cost base will allow you to design rates which tail off at the point at which full recovery has been made
Of course a canny FD will always consider whether it is best to take advantage of such times by making super profit , or by cutting the rates in order to attract more orders (at the risk that those rates will be remembered all too well by equally canny procurement people) or by a combination
06 Jul 2012 04:07 GMT
Apart from Employee payroll, the rates quoted by a Contractor also includes Mobilisation/Demobilisation costs , transport to and from from the work site to home, administrative overheads, food and accommodation, etc. These costs do not change if the employee works more or less than the normal hours.
Hence, the Overtime pay is balanced by these fixed costs - justification that OT hours should remain the same
Edward Willey III
09 Jul 2012 10:43 GMT
I do not agree that all necessary overhead is included in the regular time rates. Imagine that the prime contract calls for labor to be performed Monday to Friday. Vendor does not have full time staff based in the city where services are being performed, so it asks staff on the other side of the state/territory (imagine that you are in a place like the US or Canada, which have numerous provinces) to drive into the work location. On Wednesay, prime customer requests overtime services on Saturday, perhaps for something like an equipment cutover on Saturday night. Vendor may be required to pay for not just 1 additional day of travel/accomodations, but 2 days. I think your assumption is that vendor will not be liable for additonal costs at all. As I have illustrated, this is not necessarily the case. Also, in the United States and other places, the law may require payment of 1.5 times the base rate of pay for each staff member performing services beyond the first 40 hours per week.
In this example, at least, not only are additional "overhead" costs required, but extraordinary costs may apply, too.
From an efficiency perspective, it would be inefficient and a serious disadvantage to prime customer for vendor to include a full week of travel/accomodations in the base rates.
In sum, I think that the argument you make works only under a certain set of facts. Once we change the facts, the argument breaks down.