Overhead - The Missing Ingredient
The majority of problems in our industry can be traced to two fundamental mistakes in business math.
First is the fact that 90 percent of PHC contractors tend to calculate overhead and profit as a percentage of cost, rather than selling price. Second is their widespread failure to accurately measure and apply overhead expenses.
I have written and lectured extensively about the first problem and will continue to address it. Here we'll focus on the second monumental blunder. I'll do it in a question-answer format that responds to some of the typical questions and misconceptions I hear from contractors around the country.
What should be included in overhead?The basic components of a selling price are direct labor (including permits and fees), material, overhead and net profit. All of this ultimately adds up to 100 percent of the selling price.
You know to the penny how much you pay your workers in hourly wages, as well as the cost of any permits and fees associated with a given job. To that must be added the hourly costs of fringe benefits. If you don't have that figured out, shame on you.
You also know exactly how much you pay for most materials, likewise for direct labor. Consumables - such as solder, flux and chemicals - cannot be priced with precision. Instead you must establish a charge that is applied to overhead for these items, otherwise you end up paying out of your own pocket.
Most progressive contractors break out a trip charge or "diagnostic fee" to cover the cost of travel to the job. Some apply this charge to the job once the customer agrees in writing to let you proceed. Others keep it as a separate, billable line item. The choice is yours.
Everything else is overhead. The list below shows a sample breakdown from an actual PHC company. Different companies may itemize in different ways, but if your breakdowns don't include dozens of different line items, you are probably overlooking expenses that you end up eating. If you don't charge for it, it comes out of your profit or income.
What items are most commonly overlooked?To begin with, the owner's salary, plus his wife's and any other office salaries you might have. Slavery was outlawed in this country in
1863, but still exists in many PHC companies where the spouse runs the office and keeps the books without compensation or else makes less than she could earn flipping burgers at McDonald's! In fact, the owner also works for free if his labor selling price does not include paying himself for the time he spends working in the office wearing the hats of executive, estimator, sales rep, etc.
He typically omits it in order to keep his prices down, then expects to live off the profits. However, if you think there will be any profit left over from pricing "competitively" with guys charging $30 to $50 an hour or less, you probably also think that money grows on trees. Just go out and look for some to pick. You'll make as much money as you will in the plumbing business, and the work isn't as hard! If you cover a salary for yourself in your labor charge, you'll at least assure yourself an income even if the business makes no money. This will keep a roof over your head.
Most contractors also fail to account for depreciation of tools and equipment, insurance and other expenses that demand a bit of sophisticated accounting.
Keep in mind that tools and equipment will break and wear out. Then they need to be replaced. How do you pay for them? Out of non-existent profits? The best way is to charge each and every customer a small portion of the total cost. This is the purpose of overhead
I work out of my home and drive an old truck that's already paid for, so I have hardly any overhead.Baloney. If you work out of your home, or garage or basement, it is costing you money in both direct and indirect ways. That is space you can't use for household purposes, so your customers ought to subsidize it. There also are directly measurable costs for heat, light, cleaning, etc.
Let's say the electric bill for your shop area is $100 per month and you average 100 billable hours of labor each month. This means you should factor in a $1 overhead charge for electricity in every billable hour you sell. Over the course of the year this will add up to $1,200. Big chunk of change, huh? Do the same for the heat, telephone, stationery, office supplies and so on. Think of how many thousands of dollars a year would slip away by ignoring such items.
Yet that's exactly what so many contractors do, then they wonder why they're going broke. You must keep track of all business-related expenses and boil them down to a per-hour basis. Then add them all into your selling price of every job.
As for the truck that's paid for, keep in mind that it will not run forever. From the moment you take it out of the dealer's showroom its value begins to decline. Eventually it will wear out, and even before then it will eat up lots of time and money in fuel, maintenance and repairs.
Again, who pays? What happens when it wears out? Where will you get the money to replace it? The only sensible answer is that every one of your customers should pay a little bit towards its upkeep and replacement in the form of an overhead charge for vehicle expenses. Identify how much it should be and add it to your hourly labor charge.
Heck, if I start adding up all those nickels and dimes and charging my customers for them, my rates will be too high!
This is the crux of the stinkin' thinkin' that has ruined our industry. Let's examine the logic behind this statement. Contractors feel they can't get away with charging higher prices, so they pretend that certain expenses just do not exist. In order to hold down their prices, they don't bother charging the customer for their lights, heat, stationery, advertising, fuel, insurance, professional fees, etc., etc., etc.
This would be a viable strategy if they could convince their utility companies, insurance agents or lawyers to start providing those services for free! Most, however, eventually end up having to pay those bills - or else end up in bankruptcy court, which is happening with ever-increasing frequency throughout our industry.
There is some validity to the complaint that if everyone else in a given market is charging $40 an hour, you might find it hard to charge $80.
That's why I favor a flat rate pricing system to avoid such comparisons. However, whether you use flat rate or time and material pricing, the key point is to make sure you cover all your costs. For instance, if your overhead and direct labor add up to $50 an hour and your profit goal is 25 percent, that adds up to $66.67. You simply cannot charge $40 an hour and make a go of it.
Many people think they can make it up via material markups. I addressed this in my last article in the May issue. There is a limit to how much you can mark up material prices in today's competitive market, and you might still lose money on jobs with high labor and low material content.
Also, relying on material sales for your profit margins creates the temptation to load up customers with unneeded items.
If you disagree with any of this, please tell me where I'm wrong. Can you get away without charging the customer for your business expenses? Do you make so much profit that you can afford to "eat" many of the items just discussed? Does it make sense to charge below-cost labor rates? How long can you continue to do so and stay in business? While you mull these questions over, I'll get busy on the next article, which will provide some sample computations on applying dollar-per-hour overhead.