Science, not art, and certainly not guessing
by: Irv Chasen, 12/1/2004
If I were to ask 10 contractors how they calculate and apply overhead (indirect expenses) to either their estimates or time and material work, I would get 10 different answers. When further questioned as to how they arrived at their numbers, most of their methods would be arbitrary, or involve some element of guessing.
I'm sure of this, because for nearly 40 years I have been teaching, writing, and working with contractors on a one-to-one basis. In doing so, I have reached thousands of contractors throughout the U.S. and Canada (and even in Australia), including over 47 different types of trades. By far, the majority of those who have attended my program or those I have worked with one-to-one had no clue or scientific method for calculating and allocating company overhead.
This is not to say that of the countless contractors I have encountered all were doomed to failure. On the contrary: Many have been extremely successful, but they too found they could still fine-tune their numbers by implementing a more scientific approach. As one very successful mechanical contractor stated, "I have a good business and I make a lot of money, but I'm not sure why. And that bothers me, because if I make a lot of money and don't know why, I could lose a lot of money and not know why."
Most contractors become involved in their respective trades because they have the technical skills to get the work done, which unquestionably is a large part of the basic foundation that enables a contracting business to grow and prosper. If you don't do good work, no business practices (short of fraud, anyway) will save you. Now, when we couple their skill to a better understanding of cost accounting (number crunching), the odds in favor of success dramatically improve. When overhead recovery becomes a science instead of a haphazard guess, profit or loss becomes a science-which can be monitored on an hourly, daily, or completed job basis.
Many contractors rely on their accountant to provide a profit and loss statement quarterly, semi-annually, or annually. Whereas this professionally provided information can be somewhat useful, it is, in most cases, after-the-fact information, because it does not indicate which jobs caused the results. It doesn't tell you where or when you made or lost money.
Why is that information so important? Here is a quote from a ceiling and flooring contractor who attended one of my programs many years ago: "While the program is not the panacea of all ills that befall a contractor, it certainly has been one exceptional forward step for us in keeping tabs on our overhead and letting us know not only where we stand, but most importantly, where we stand now-now, while we can still do something about it."
The ability to nail down profit or loss on an hourly, daily, or job basis by far is a better approach to financial success. When the contractor has made overhead recovery a science, the professionally prepared P & L statement will simply confirm what the contractor already knows. He will have been "doing something about it now" the whole time.
Gross profit is commonly viewed by contractors as a measure of their degree of financial success. The trouble, as I like to say in my seminars, is that a contractor could have substantial gross profit on every job he completes and still go flat busted.
We survive or prosper on net profit, not gross profit. Therefore, when the contractor has a scientific method of subtracting the overhead from gross profit, the bottom line will immediately reveal the real net results.
For most contractors, it has been proven time and time again that the best method of applying overhead expense is to field labor only, with no overhead apportioned to material or other job costs. For the homebuilder or general contractor who employs little or no field labor, their overhead cost may be best applied to their subcontracting expense.
One method many contractors use to allocate overhead is to add a percentage to labor and material combined. This may work well for some companies, particularly when the labor to material mix is about the same on most or all of their jobs. However, in most cases this will not hold true. Therefore, relating overhead to labor and material combined can produce mixed results. The following example will illustrate this point.
Charlie is the owner of a hypothetical contracting business. He has taken the time to budget his next year's operating expense, something very few contractors do. Next year's expense budget is as follows:
- Budgeted field labor: $500,000
- Budgeted material cost: $250,000
- Budgeted overhead: $525,000
At this point, overhead is 105 percent of labor cost (525,000 / 500,000 = 105 percent). Overhead would be 70 percent of labor and material combined (525,000 / 750,000 = 70 percent).
Charlie decides that his overhead allocation should be based on labor and material combined, or 70 percent. Using this system of allocating overhead, we will review four possible jobs to see the amount of overhead each would produce.
If Charlie had chosen a labor-only method of recovering his company's overhead instead of a labor and material combined method, the overhead recovery of each of the above jobs, A through D, would have been $1,050 (105 percent of 1,000 = 1,050). Note that each of these four jobs has the same $1,000 labor.
When allocating overhead on labor and material combined, Job A would recover only $840 overhead, $210 short of the labor-only method. Job B would recover $980 overhead, still $70 short of the labor-only procedure. Job C would contribute $1,120 overhead, $70 more than the $1,050 if overhead was on labor only. Job D would produce $1,050 overhead, which is the same as if the overhead was on labor only.
Why did Job D, using the labor and material method of allocating overhead, produce the same amount that would have been produced in a labor only method? Because in Job D, the labor to material mix-two to one-is exactly the same as the annual budget ($500,000 labor to $250,000 material).
Now, the big question: Just how many jobs will Charlie's company produce next year that have the exact budgeted mix of labor and material? There may not be any!
Using an overhead allocation system based on labor and material combined sometimes produces too little overhead dollars and sometimes too many, as with the more material-intensive jobs like Job C. Too much in overhead could make Charlie's company less competitive on a material-intensive job, and those are the types of job that most contractors would prefer. Why? Because material-intensive jobs afford a contractor an opportunity to produce a higher volume of work with the same labor force. Remember all cost, labor, material, and overhead will be marked up for profit.
There is a host of other reasons for allocating all overhead to field labor only. Some more of these will be discussed in future articles.