How to Think About Overhead in Your Practice
There’s something funny about accountants. We understand the formula for profitability: Revenue minus overhead equals profits. But we typically think about overhead the wrong way, at least from a practice management perspective. Overhead is an important part of the equation. In my experience, it’s rare that accountants or dentists understand how to properly think about overhead and its effects on profitability and cash flow.
Have you ever compared the wide range of overhead percentages brought up at a dental-study-club meeting? Even in a small group of dentists, they can vary from 40% to 90% of revenue. This variability makes absolutely no sense. So, the first step in managing overhead is to adopt a classification method that allows the dentist to quickly understand whether profits are being excessively drained. Many accountants use a standard chart of accounts for all of their small business clients, one that often fails to distinguish the essential overhead tracking elements in dentistry.
To illustrate the overhead classification problem, let’s compare two study club members. An older dentist believes his overhead is only 40%, while a younger dentist states her overhead is 90%. The older dentist practices as a sole proprietorship, employs no children, has no retirement plan in the practice, and owes no debt. The younger dentist practices as an S corporation, employs children in the practice for tax reasons, makes significant retirement contributions, deducts a vehicle for tax purposes, and has substantial depreciation deductions and loan interest typical for a young practice.
Let’s discuss the tax-related items first. The retirement plan, depreciation, and financing costs in the younger dentist’s case are not really “overhead” from a practice management perspective and should be classified differently. With proper overhead classification, any dental practice can be compared to any other. It is, of course, still very important to consider how tax, debt, and retirement planning impact overall wealth creation, but not in the context of dental practice overhead. Clearly, a different overhead classification method is needed. Since accountants create financial statements on an “income-tax basis,” deductible items (e.g., depreciation, children employed in the practice, retirement plan deductions) are classified as overhead, which creates confusion for how overhead affects profitability.
Following is an example classification method that will allow you to understand true dental practice overhead and its effects on profitability from a management perspective. First, your income statement must reflect production, adjustments, and collections on the top line. Since dental practice overhead is driven by production, it is important to see the effects of reduced-fee arrangements in adjustments to production. Perhaps you have poor profitability because of reduced-fee arrangements, not because of high overhead expenditures.
Following production, adjustments, and collections is direct overhead, which consists of only five items: staff expense, lab expense, dental supplies, facility expense, and promotion (or marketing) costs. These five items ideally should be about 48% of production in a general dentistry practice. It is important that salaries paid to relatives (including the dentist’s salary) not be reflected in staff expense to avoid distorting overhead. These salaries should be reflected below the practice profit line as “relatives on payroll” or “dentist’s salary.”
The final overhead category is indirect overhead, which includes expenditures such as CE, office supplies, and insurance and accounting fees. Indirect overhead ideally should be about 8% of production in total. From a classification perspective, it is important to exclude deductible items such as interest expense, depreciation, and owner expenses (e.g., auto expense or retirement expense) from direct and indirect overhead. These items all go below the line of practice operating profit. They do need to be tracked and classified, just not as dental practice overhead.
Once your overhead items are properly classified, it will be easy to quickly determine if you have an overhead problem. Ideally, practice overhead in general dentistry should total 56% of production. As with many cases, it may be that overhead isn’t the problem at all. Rather, “overhead” issues may actually be related to production or personal-finance problems-specifically needs, wants, and savings. These are issues with cash flow or wealth creation, not overhead, and should be addressed differently.
Reprinted with permission from Dental Economics
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