Remember back in high school how your math teachers would always tell the class to pay attention because you'd need to remember this when you were older?
Well, the math teacher was right. There are some important, basic math skills that contractors must know to survive and prosper in business.
Growing up in the PHC industry as a plumber's son, I learned early on in my career that there are a bunch of wonderful, hard-working people in this industry. The unfortunate thing is that these same hard-working people, as a group at least, are woefully underpaid and many who are in business for themselves struggle for many years just to survive.
Why does this happen? Well, I find that in most cases, it's due to a lack of understanding of those math classes back in school. Without these skills, contractors make mistakes and that causes them to struggle financially in their businesses. Let's take a look at some of the biggest mistakes being made.
The Breakeven PointWithout a doubt, the biggest accounting mistake I encounter in working with the PHC industry is the improper calculation of the contractor's breakeven point and corresponding selling price.
Retired PM columnist, mentor and friend Frank Blau wrote and taught this subject for more than 20 years. Yet, it remains today the No. 1 accounting mistake made in the industry. It is actually a combination of a few other accounting errors. Let's review the contributing factors in more detail.
OverheadIt is astonishing to find that this is still a foreign term and for many contractors today. What are overhead costs? They are the costs associated with being in business that are not directly attributable to a specific job. These costs would be incurred whether or not a sale was made. They include items such as owners' salaries, office and administrative salaries, rent, liability insurance, utilities, etc. Overhead costs are also known as "operating expenses."
All of these costs are a component of the breakeven equation and must be included in properly determining your selling price. The breakeven equation is:
Breakeven point = Material Cost + Direct Labor Cost + Other Direct Job Costs + Overhead Costs
BE = MC + DL +OH
This equation holds true no matter how you price your services.
Unbilled LaborThis is a component of overhead costs. What is unbilled labor (or unapplied, unproductive time)? It is the labor cost incurred that is not directly billable to the client.
There are the hours that will be spent driving to the jobs, picking up materials, doing take-offs of prints, preparing estimates, attending conventions, taking continuing education courses, etc. These are not billable hours and cannot be directly billed to the client. They are, however, a component of calculating breakeven. Other terms used for this cost component are "unapplied" or "unproductive" time.
How do you start tracking the billable and unbillable time if you're not already doing so? It's not as difficult as you might think. It's as simple as keeping a log or spreadsheet that tracks each job that you do.
Again, it doesn't matter how you bill your clients (time and material, flat rate or contract pricing). You can make it as detailed as you like but, at a minimum, record the number of hours you bill out for each job or each task performed and also track the actual number of hours worked on each job or task billed out.
In a time and material system, every hour worked on the job is billed out (travel time and shop time are handled a variety of ways but should be accounted for somewhere in the billing system).
In a flat rate system, each task is set up with a standard number of hours for each job. The hours that are billable on each task are the hours that are built into the task price. It doesn't matter if it takes the employee more or less time than the standard hours for the job. The billable hours are the standard hours set up for that job.
If a job has two hours built into it and the technician took only one and a half hours to do the job, the technician would get credit for the two hours associated with the job. On the other hand, if the technician took three hours to complete the job, the technician would still only get credit for two billable hours.
Tracking the billable hours and the actual hours worked allows you to calculate the productivity percentage for each field technician and the department or company as a whole as well. This calculation is a crucial component in properly calculating your pricing and keeping score in your business. The productivity (or billable) percentage is calculated as follows:
Billed Hours / Actual Hours Worked = Productivity %
Markup vs. MarginOnce the overhead and unbilled labor hurdles are cleared up, there's still one last hurdle that often trips up contractors as they head down the home stretch.
"Markup" and "margin" often are used interchangeably. They shouldn't be. Markup is calculated based on cost. Margin is calculated based on the selling price.
An example may clarify the difference in the two terms. After the answers are calculated, the proofs are shown for each method. Remember, these are math equations and are provable.
Material (M) Cost $ 250
Labor (L) Cost $ 250
Overhead (O) Cost $ 400
Breakeven (BE) Cost $ 900
Markup Method: 25% Markup
$900 X 0.25 = $225
Markup - $900 + $225 = $1,125 Selling Price (SP).
Proof of Markup: $1,125 - $900 = $225 Markup.
$225/$900 = 25%.
Margin Method: 25% Margin
$900 / 0.75 = $1,200 Selling Price.
The math term for this is "reciprocal" - a pair of numbers whose total equals 1. In this case, 0.25 + 0.75 equals 1.00. If the margin goal was 20 percent, the costs must equal 80 percent, etc.
The formula is:
Selling Price = Material + Labor + Overhead Costs
100% - Margin % Desired
Proof of Margin: $1,200 - $900 = $300 Margin
$300 / $1,200 = 25%.
The common mistake made is the mixing of these terms and calculations. What commonly happens is the contractor multiplies the $900 cost by 25 percent and says the result is a 25 percent margin. This is not true! Remember, margin is calculated based on the selling price.
$900 X 0.25 = $225
$900 + $225 = $1,125 Selling Price
$225 / $1,125 = 20% Margin
Now that I've explained the markup method to you, I'm going to ask you to forget the whole term. Do not use the term or the method. When you use the markup method improperly, you reduce or eliminate any potential profits on the project. And it's most often used improperly.
Use the margin method instead. It is simple and always accurate.
There are a number of other accounting and business management mistakes being made by many contractors. These math calculations have a large impact on the financial health of a business. Do not be intimidated by the numbers. Educate yourself. You do not need to be a CPA or have an accounting degree to understand what you need to know. Talk to your bookkeeper, controller or CPA about these issues. If they can't help you learn what you need to know, find one who will get it done.