The True Cost of Overtime

When you back out overhead, time-and-a-half wages for overtime hours may work out to a wash. But not always ... October 2, 2007

I've been asking different groups of trade contractors what they think about the cost of overtime. Legally you are absolutely required to pay your employees time and a half as a wage for the OT they put in. So how do you look at that additional labor cost? If you have planned and contracted the job at your regular time rates, where does that money to pay for OT come from?

Forum Responses
(Business and Management Forum)
From contributor S:
This is the way I see it. Since all your fixed overhead is figured for in a standard 40 hour work week, the overtime pay actually costs you no additional funding. The additional pay, accompanying insurance costs and small increase in electrical usage, is offset by the fact that you don’t consider all your fixed overhead into those hours. It only really comes down to productivity. Too much OT causes fatigue and production will drop.

I pay salary. So they bank hours when working extra or owe me hours when they work less. If needed, pay is adjusted at end of year bonus based on total hours worked. It is a very loose policy. As long as they produce, I don’t care if they work less, but make sure they are compensated if they work more than usual.

From contributor T:
The main problem with overtime is it gets to be a habit. We pay our crew very well and expect a "get ‘er done" attitude from them. If schedules are not realistic, I'm not doing my job.

From the original questioner:
Congratulations and pardon the clichés, but right out of the box you hit the nail right on the head with what I was going to say. Paying for overtime doesn't really cost a contractor anything. It doesn't make you any money (unless you have a contract mechanism in place to charge a premium for that OT), but it doesn't hurt the contractor.

While I've actually been talking about this for years, I bring this up because just a few weeks ago I was sitting in a coffee shop drinking my coffee and I could not help but overhear two contractors talking about overtime. One of the guys was saying he pays his people straight time for overtime (which is illegal) since he "hadn't figured OT into the cost of the original bid." I was thinking aside from the fact that he was illegally robbing his employees’ pockets, he hadn't really figured anything since OT doesn't really cost the contractor anything or just didn't really understand the math involved.

Let’s say an employer pays a carpenter a wage of $25 per hour. And then let’s say his burdened rate (wage + variable overhead cost) brings the cost of that carpenter to $31.25. The contractor (using a Capacity Based Markup) then marks up that cost 2.12 (the median markup rate for remodeling contractors using a Capacity Based Markup) to cover his or her Fixed Overhead costs to come up with a billing rate of $66.25 per hour.

If that employee works 40 hours in a week, those 40 hours have contributed $1400 towards the company's overhead costs that week, which is the allotment you would expect that employee's work to do during that week ($66.25 per hr Billing Rate - $31.25 per hr. Burdened Rate = $35.00 per hr. Fixed Overhead Costs, $35.00 per hr. Fixed Overhead Costs x 40 hrs = $1400). So if all the employees work 40 hours during a week, all the Fixed Overhead Costs have been covered for that week.

Therefore, if the company's overhead costs for the week are all paid for at the end of a 40 hour week, if that employee then works putting in 8 more hours of overtime since his or her associated Overhead Cost for the week has already been covered, then in theory if the contractor continues to bill for the overtime at the regular rate, he or she has earned an extra surplus of $280 for that time. That's obviously not the end of it, though the contractor by law has to pay the employee time and a half for that overtime, so that works out to the $25 per hour regular wage x 1.5, which comes to $37.50 x 8 hrs = $300. (While WC is based on payroll, it is based on regular time and not the time and a half wage, so it doesn't figure into the equation.)

So if a contractor (with these wage and markup figures) has an employee work 8 hours of overtime, it only costs that contractor $20 ($300 - $280 = $20), which is for all intents and purposes a wash ($20 / 8 hrs = $2.50 per hour).

If a contractor charges the client time and a half for that premium time ($66.25 x 1.5 = $99.38), the contractor then makes a surplus of $245 for that extra eight hour day.

I'll never argue that the contractor shouldn't get that extra $245. Far from it, in fact. If the contractor has delivered a premium value added service in having that employee work overtime to speed up the delivery of the project, they've earned that premium. But the math involved is not at all what most contractors think it is.

The point I'm making is if you can charge more for OT, you certainly should. If you’re working T&M and the owner/client approves the use of OT, you should certainly charge a premium for it. Same thing if you are on a fixed price job and the client asks for acceleration, then you charge for it.

But let’s say you’re on a fixed price job and for whatever reason, you’re a day behind through no fault of your own and with no penalty (in other words, you were behind because of something like a rain delay and not just because something took longer than usual). Would you work the weekend paying your people OT even though you figured the job at the regular time rate, just so that you can start another job you had previously scheduled to start on Monday and therefore put off it's start until Tuesday? The answer is you work the weekend OT at the regular rate (it's a wash), but because you are able to, then start the next job on time and you haven't lost any throughput days.

My whole point is that Marginal Cost difference between Regular Time Hours and Overtime is not nearly as big as most contractors mistakenly think it is.

In the example I put forth above, the OT actually cost the contractor money. It ended up costing 20$ per day per person for OT. How often have in our careers managing projects have we heard ourselves say "What I would give for just one more day"? Is getting back a day in the schedule worth an extra $20 bucks to you?

The "not figuring OT into the cost of the original bid" is a rationalization I hear at least once a year from some contractor somewhere. On my first job ever in the trades 30 years ago, my boss said the same thing, and over the year and a half I worked for him, I probably put in 50 days of OT that I never got fairly compensated for.

One of the arguments against overtime that I do think is valid and several real studies have been conducted on is that as employees work more and more OT, their productivity for all hours, not just the OT ones, starts to go down. In other words, job fatigue starts to set in. As you get into overtime, the effectiveness productivity wise for those hours diminishes. There are construction specific studies that have been conducted that show that extended periods of overtime (more than 4-6 weeks worth) can lead to up to a 15% reduction in worker productivity.

But there is a remedy that's been discussed that I agree with, called The Goldilocks Solution, which is to have not too much, not too little, but just right amount.

I also personally happen to think that an employee that has a life outside of his or her job is a better employee when they are on the job. I like to see my own employees coaching the little girls’ soccer team on weekends. Going on ski trips with their families or just taking up gardening and reading a book, just do something else.

From contributor L:
I agree that OT doesn't really add to the cost of a job as long as the employees are fully functional all the time. Too much OT makes Johnny a dull boy and less productive. There are always a few that will try to abuse OT pay, but for many it provides a little extra cash for toys or the like.

From contributor R:
One caveat to your line of thinking that needs to be mentioned is the relationship between overhead and overtime as it relates to the overall sales level. If your overhead is applied to your labor based on all of your labor being utilized, and ultimately you do not utilize that labor, then the overtime could still be at its full cost, and the overhead may not even be covered.

For example, your overhead is based on 320 man hours for the month (2 men at 40 hour weeks for 1 month), and you only utilize 240 of those hours, and 40 of those 240 are at overtime.

In other words, you work your two men for 60 hours each on week 1 based on a job deadline, then you send them home for lack of anything to do for weeks 2 and 3, then you work them for 60 hours each on week 4, again based on the job deadline, but possibly lacking materials and or information to start during the two weeks they have nothing to do (it would never be this obvious, but to illustrate my point, I chose this example for simplicity’s sake).

This scenario (again, not to this extreme) is not all that uncommon in our industry, so it needs to be said that overtime is not always free, or at a low cost, especially when your overhead is applied to labor only.

Overhead is a lot like a narcotic, use it once, and you seem to need it over, and over, and over again. I personally choose the Nancy Reagan view on overtime - Just say no. My view has always been that if we need to work overtime, I (not my employees) am doing something wrong. I choose to utilize outsourcing rather than labor to buffer the inevitable spikes in demand.

From contributor I:
What seems to work best for us is to allow limited voluntary overtime. Some people can't do overtime well, and others excel at it. We have a well-cross-trained crew, so we use the volunteers to work our bottlenecks (theory of constraints applies here). That way a few motivated people can significantly increase our output. I get lots of resistance to mandatory overtime for everyone, and lots of people call off, saying they can't make it. So we use those that are into it. And as mentioned, unwanted overtime can burn people out. Those that volunteer tend to keep the pace regardless. Keeping good attitudes is so helpful in making the shop run smoothly.

From contributor G:
I'm curious, since you mentioned TOC and all, how big is your shop? What other ideas from TOC have you successfully implemented? I'm particularly interested in scheduling. I've read all Eli's books over and over again, but haven't been able to put my finger on it. I just reread the critical chain, hoping to get some help with my new position as a project manager.

From the original questioner:
I really don't think that we in the custom cabinet industry have bottlenecks in the shop. I know that I am going to get hammered for saying this, but I think it is true.

Is there a machine in anybody's shop that runs the whole time? There isn't in mine. We all have way more capacity in our shops and with our machinery than we can use. The true bottleneck is in getting the information from sale to ready to work on. I think it is attributed to two factors.

1) We are not really manufacturing the same things over and over again. Every job is different and the information on each job is different. If we were making widgets and had an endless supply of widgets that need to be made, then we would be manufacturing.

2) The bottlenecks are lined up so that the biggest bottleneck is first. Cutting and milling is the first thing we do with a job and it takes the most time. In our shop we can assemble faster than we can cut, and we can finish faster than we assemble. The problem comes when the guys in the shop have worked themselves out of a job. This happens all the time. Our saw guy is waiting for me or my project manager to get them the information and materials they need. After that it flows very smoothly through the shop.

I do think that we as shop owners need to find ways to make things in the shop go faster and more efficiently, but I don't think we really have bottlenecks as described in "The Goal".

From contributor M:
I agree with you. After reading "The Goal," my first thought was that the whole "eliminate the bottleneck" theory applied more to cabinet plants than cabinet shops. Those of us with a smaller number of employees probably have their crews cross trained to at least a reasonable degree, so the amount of time an employee spends standing around waiting for product to work on is quite minimal (or in my case, nonexistent).

From contributor Y:
Here’s some food for thought… Maybe the constraint isn't a department, or a machine. Maybe it's a person, not someone who isn't doing their job, but someone whose job is too large to effectively handle everything at once. I'm thinking of maybe a manager, etc. who isn't quite able to create meaningful tasks for everyone fast enough to keep ahead of the employees.

From contributor I:
I read Eli's book, which is excellent, but I have known for a long time that I couldn't get more out of my shop than the most constrained station. I take the simplest view of TOC, which is to work your bottleneck. I have almost 50 people working for me (about 40 work making doors in a 14K sq ft shop), but started with just myself. It wasn't until I was big enough to have supervisors that I could stand back and take a more philosophical view of what was happening. From my JIT stuff in college, I knew to not pile up inventory between stations. It may be easier to do with doors than cabinets, but it is fairly easy to walk through the shop and see where the bottlenecks are.

From contributor E:
Timely information could be considered a bottleneck. There are many different things to define throughput. If a part on an assembly line is not there for the next person to do his job, it’s no different than information not being there for someone to do their job. And the only thing worse than no info is bad info.

From contributor L:
Most of the time our constraint is information: too slow getting to the shop, errors, not updating the bill of materials, then the wrong item goes to purchasing, etc. When the schedule (such as it is) is already tight for production, bad information is a real killer. 20-man shop.