I left off my last column by inviting you to fill out the missing blanks on a worksheet containing four hypothetical contracting jobs with different overhead factors. I requested that you mail them back and also identify the most desirable job of the bunch.
Predictably, the answers ranged all over the place, but more than half of you who responded did come up with the correct answers shown on page 47. I would love to take that as a sign that our industry is getting its act together when it comes to business knowledge, but I’m afraid there is a simpler and more disheartening reason for the high percentage who “passed” the course. I know from my teaching experience that most PHC contractors are totally befuddled by these worksheet problems, and they aren’t inclined to take the time to participate in this exercise. As usual, it is the more diligent and knowledgeable contractors who find intellectual stimulation in business problems, just as they are the ones you find attending seminars, participating in industry affairs, etc.
In other words, “Them that got, get more; them that ain’t got, get loster still!”
Anyway, “them” of you that “ain’t got” perhaps can move up into the “got” category if you stay with me awhile as we review the arithmetic and logic behind these sample jobs. To begin, keep these important facts in mind:
1) Direct cost for all jobs is $1,000.
2) Labor cost is $25 an hour, including fringes.
3) Overhead is 15 percent of selling price.
4) Dollar-per-hour overhead is $10 per hour.
5) Net profit goal is 10 percent of selling price.
Job 1: The correct selling price for this job is $1,333.33. Overhead of $200 is 15 percent of the selling price, and net profit of $133.33 is 10 percent of selling price.
By crunching numbers, we find that 20 manhours are involved on this job. Dividing net profit of $133.33 by 20 manhours produces some useful information, namely net profit of $6.65 for every manhour of work. Keep this number in mind as we review the rest of the jobs in this exercise, particularly Job 4.
Job 2: The correct selling price for this job is also $1,333.33. We arrived at this price in a slightly different manner, with overhead being identified in terms of dollars as opposed to percentage of sales. In this job scenario, overhead is $10 per productive hour of labor. Multiplying 20 hours of labor by the $10-per-hour overhead figure produces total overhead of $200 for this job.
At this point we add material cost of $500, plus labor cost of $500, plus total dollar overhead cost of $200 and, presto, we arrive at the breakeven or “static point” of the job, which is $1,200. If we want to operate as a non-profit entity, we can sell the job for $1,200 and feel assured that all costs have been covered.
I know of many companies who operate on this basis for a portion of their fiscal year in order to “crack the nut.” The thinking is that they’ll let the competition “thin out” and then go after profit in a serious way. However, a word of caution is in order — the crystal ball must be a very clear one. Your forecast of future work in the marketplace better be accurate. A better way is to actually make some money on the jobs at hand — how’s that for a revolutionary idea!
Since the profit goal for this job is 10 percent of selling price, we need to realize that $1,200 equals 90 percent of the selling price. We DO NOT, I repeat, DO NOT calculate profit by multiplying $1,200 x 0.10 = $120, and add that to $1,200 for a selling price of $1,320, although, unfortunately, that’s the way it is done by most people. They come in for a big surprise at the end of their fiscal year.
We DO divide $1,200 by 0.90 to come up with a correct selling price of $1,333.33. This way we do not cheat ourselves out of $13 and change, and by continuing to do so we can end our fiscal year with a smile on our face and some retained earnings in the bank for future growth, etc.
Job 3: As with Jobs 1, 2 and 4, the total direct cost is identical, $1,000. However, as you can see, the ratio between labor and materials is quite different.
Again, one must determine the number of manhours involved by dividing total direct labor cost of $700 by the hourly labor cost of $25 to determine that there are 28 manhours. This is essential information needed to proceed to the next step, which is to calculate total overhead in dollars for the entire job. Simply multiply 28 manhours by the hourly overhead cost of $10 per hour, to arrive at a total job overhead of $280.
As in Job 2, add material cost of $300, plus labor cost of $700, plus overhead cost of $280, for a breakeven figure of $1,280. Again, this is 90 percent of the selling price, and again the “blind men” will multiply $1,280 by 0.10 then add the result for a wrong selling price of $1,408. “Wise men” will divide $1,280 by 0.90 to calculate the proper selling price of $1,422.22, which produces net profit of $142.22, or 10 percent of selling price.
Net profit per manhour is $5.08, compared to $6.65 for Jobs 1 and 2. Very interesting. Read on.
Job 4: Now let’s take a serious look at the most interesting job of all. Since we’ve already reviewed the basic arithmetic in Jobs 1, 2 and 3, let’s skip that and simply refer to the answers found on page 47 so we can get quickly to a very important point. Also take note of the fact that on the answer sheet I added one more column of numbers that was not contained on the original worksheet, pertaining to net profit dollars attributable to various costs of the job, namely materials, labor and overhead.
Two key facts stand out after all the numbers crunching is completed. 1) Total manhours amount to 12 hours and dollar-per-hour net profit amounts to $10.37 per hour. 2) Net profit per hour for this job is 104 percent greater than the per-hour profit for Job 3, and almost 56 percent greater than the net profit per hour for Jobs 1 and 2.
What’s it all mean? Well, several respondents took up my request to identify the most desirable job of this bunch.
Richard Czeiner (Abbott Mechan- ical Contractors, Cherry Hill, N.J.) stated, “I can do 2 1/3 more jobs with the same labor cost if I do 4-type jobs and thereby earn 2.05 times as much profit controlling the same manpower.”
Let’s examine his financial logic:
By 2 1/3 more jobs with material costs higher than labor costs he is comparing the 12 manhours of labor needed for Job 4 compared with 28 manhours for Job 3. The 12 manhours at $10.37 per manhour net profit projects to a total profit of $290.36 for 28 manhours of work. By way of contrast, 28 manhours in Job 3 brought in only $142.22 in net profit. That’s what happens when labor cost is proportionally much higher than materials cost.
Ned Kauffman (Kauffman Mechan-ical, Dornsife, Pa.) states, “From my point of view, Job 4 is the best job because of the minimal labor involved, and it is the only job where the profit actually exceeds the overhead.”
W.C. Hinton of Fitzgerald, Ga., likes Job 4 for the following reasons: 1) More material. 2) Less labor. 3) Less overhead. 4) Less chance of loss due to labor overrun.
All of these gentlemen are “right on!” Based on the responses I received, about 20 percent correctly determined that Job 4 would be more desirable to pursue over Jobs 1, 2 and 3 — even though it entails the lowest selling price and lowest profit dollars.
Nonetheless, it has the highest profit as a percentage of direct labor cost. Since most of a contractor’s risk is in the control of labor, this job provides for the least chance of error. Although it might seem that Job 3 is better because of the larger potential dollar profit, that “potential” can quickly turn to disaster due to any number of labor snafus ranging from a foreman suddenly quitting to a journeyman’s hangover to every other human foible imaginable.
Ultimately, what I am trying to show with this exercise is that contractors must be able to identify overhead on more than one basis, and know when to apply the appropriate method to procure jobs that will produce more profit and less risk by using labor in a intelligent manner. Realistically, applying markup in the manner used for Jobs 1, 2 and 3 might drive you out of the marketplace. You want to try to apply markup as it was done for Job 4.
The Material Factor: There is another serious implication to consider. The flip side of labor content is the percentage of job revenues and profit that come from the materials you supply. The importance can be seen by looking closely at the extra column I added to the worksheet on page 47, especially the numbers for our “most desirable” Job 4.
Imagine what would happen if materials were eliminated from any of these jobs for whatever reason, be it that a wholesaler sells direct to the builder or consumer, or the manufacturer sells direct to the end user, or a variety of other real-life scenarios that are taking place throughout our industry today. It is not a good situation for the contractor, nor in my opinion, for the consumer or supply houses either.
The loss of profit on materials means that the risk factor has increased, because the only “commodities” remaining to earn a profit on are labor and overhead. For Job 4, additional labor would have to be injected to replace the loss of material and earn the same net profit.
This leads to other far-reaching questions and concerns — supply of labor, need for more vehicles, increase in overhead, effects on net profit. Or how about this one: How many people will have an incentive to earn a living as PHC contractors and serve society? Think about that one, fellow contractors and our suppliers.
This scenario puts the contractor in the position of attorneys, doctors and other professionals who sell labor only. They make quite good livings, but only because they charge fees ranging from $100 an hour on up. Can we do that? Considering that we have not been able to sell our expertise for the right price for most of this century, I think the outlook is rather bleak.
Yet we have to keep plugging away. The upshot of this column and the others covering overhead and markup is to know all there is about the “mystery cost” of overhead, and reduce your risk factor by becoming the best numbers cruncher, salesperson and merchandiser you can be.