Personnel costs in the overhead of an organization can quickly get out of hand. Accordingly, it is important to maintain an overview at all times in order to identify corresponding cost reduction potential.
What does “overhead” mean in a company?
The term “overhead” includes all administrative activities that cause operating costs in the company that cannot be clearly allocated to cost units (products or services). These overhead costs, also referred to as “structural costs” or “administrative costs”, include the following cost items:
- the management and its assistance,
- the strategic management,
- the controlling department
- IT system administration,
- finance (financial and operational accounting),
- human resources development,
- the personnel accounting,
- the sales management
- the production management,
- warehouse management
- logistics management,
- the management of product development,
- the facility management
- the maintenance department
- all staff functions (process management, occupational safety, fire protection, environmental protection, protection of personal data, waste management, etc.)
However, one should look carefully when allocating overhead costs: For example, if customers pay for quality testing and verification on a product-by-product basis, the costs of the associated quality assurance measures should be allocated to direct costs. The same applies to internal and external material transports: If these material transports are necessary to manufacture the products and make them available, the costs incurred for them are to be allocated to direct costs. A gray area are the costs of foremen in production or logistics who can allocate part of their working time to specific contract productions or deliveries and book them accordingly.
In principle, this also applies to work preparation, where every order is created, and to production planning, where every order is scheduled 2for production. Finally, activities in order processing (internal sales) and in operations accounting are actually direct activities, because every inquiry, every order, every delivery bill and every invoice is handled here in a traceable manner. The costs incurred for these activities are also direct costs in this sense. However, in practice, the allocation becomes very detailed. For this reason, these expenses are usually allocated to overhead.
What function did the overhead perform?
Overhead activities are occasionally illustrated by the term of art “effort costs”. With such activities, you strive for orders, for a good working atmosphere, for efficiency, for sustainability, for occupational safety, for personal data protection, and so on.
If all overhead were removed from a company, operational activities within the company would likely continue largely unchanged for some time. However, reports required by law would no longer be prepared and sent out, corporate governance would no longer be pursued, management tasks would not be performed, and impetus for strategic and operational adaptation and further development of the organization would be missing. Overhead thus certainly has its function in companies for the management of companies and thus its right to exist.
Cost reduction potential in overhead
Despite their function in managing companies, it is worthwhile for overhead activities to regularly scrutinize their value contribution. This requires a professionally sound analysis. A careless dismantling of supposed overhead activities can be detrimental to the company. Sometimes activities appear to be located in overhead, but are actually direct and necessary value-adding activities.
Example: At a plant manufacturer, 12% of the employees were engaged in quality assurance. Such a figure is naturally tempting to make cuts. On closer inspection, a large part of these employees carried out measurements of components and the documentation of the measurement results. A measurement of each component was a customer requirement, and the customer paid for its execution. The supposed structural costs were therefore actually necessary direct costs.
Don’t be afraid to put even “sacred cows” to the test. Make an objective comparison of the direct and indirect benefits these activities bring to your organization. As a rule, there is interesting potential for cost optimization here. By streamlining these functions, you are usually also doing your organization the favor of becoming more agile.
However, assess the functions in terms of their holistic effect on your organization and identify collateral effects of a possible elimination of individual overhead activities.
Example: If you save on a coordinator, your process may no longer run smoothly afterwards. The resulting damage may far exceed the costs saved for the coordinator. However, if it becomes apparent that the process is not working on its own, but only through the use of a coordinator, skepticism is warranted. Coordinators are often used to catch inadequacies in the process. It would make more sense and be more sustainable to optimize the process and achieve ongoing coordination between the participants instead of increasing the overhead.
In many companies, savings are unfortunately made prematurely in the area of operational employees, while the administration remains very comfortably positioned. This leads to the formation of a “water head”: an excess number of overhead employees manage a minority of operational employees. Often, the argument is to secure know-how. Valuable skills and capacities are carelessly given up in the operational area.
Example: The well-known English sociologist C. N. Parkinson writes – slightly ironically – on administration and economics that all administrations have the tendency to initially extend the work to the available time and then to provide each other with work. As a result, the administration paradoxically continues to grow and would continue to work and grow even if the actual core task of the organization was completely eliminated.
A mismatch in the distribution of capacity within the organization contributes neither to its stability nor to its resilience and not only prevents economic success, but even endangers the company’s existence. Useful further recommendations can be found in the section Throughput and under Sensible cost reduction in the crisis.