Frank Blau
Blau Services

In the previous article, we reviewed some calculations in which overhead was identified as a percentage of sales, applied to both labor and materials. It was the most elementary method used to enable one to understand the percentage relationships of the various costs to the selling price.

This week, we will advance one step further by identifying overhead in terms of dollars and applying those dollars directly to productive hours figured for a job. I’ll leave you with some exercises to do on your own using this method of calculation, which I hope will open some eyes about the critical relationship between profitability and material sales.

As explained in the previous article, “productive” hours are those hours charged directly to a specific job, as opposed to the so-called “nonproductive” hours that are not charged to a particular job but must be spread across all jobs. The nonproductive hourly cost, therefore, is overhead, along with various other costs associated with equipment, office supplies, utilities, etc.

Nonproductive hours are a measure of the time spent by support personnel, as well as by field people engaged in something else besides working on a revenue-producing job, such as vehicle maintenance or stocking warehouse shelves. In order to calculate dollar-per-hour overhead cost, it is essential that all hours spent by mechanics working on a particular job be identified as a direct cost of that job. Likewise for the working owner, who may be involved in a multitude of activities ranging from estimating, trip to city hall for permits, material pickup at a supply house, or working with the tools, all of which should be identified as either direct or indirect (“nonproductive”) hours for the job at hand.

I recommend the use of a daily time card for the working owner as well as his mechanics, breaking down the time spent on productive versus nonproductive tasks. After clearly identifying productive hours, simply divide total overhead dollars by productive hours in a given period to arrive at a dollar-per-hour overhead figure. This produces some information that all contractors need.

Labor Vs. Material: Why is it important to be able to identify overhead in terms of dollars per productive hour, in addition to percentage of sales, and apply those overhead dollars to labor hours?

The main reason is that in certain job situations, where total direct cost (material and labor) may be identical, but the ratio between material and labor varies, it is advantageous to apply dollar-per-hour overhead on hours. You will see after your crunch the numbers on the worksheet problems, that where materials costs are higher relative to labor, selling prices become more competitive, while still achieving the proper coverage of overhead and profit.

Applying dollar overhead to labor hours under the right circumstances produces more profitability, even though new profit margin per job may be less. As the job scenarios will show, this is not necessarily a negative factor.

Another important reason to use this technique is that contractors can utilize labor in a more intelligent and profitable manner. Labor presents the greatest risk and unpredictability in contracting. We can peg our material cost to the penny, and our overhead cost associated with materials is relatively low, often amounting to little more than a phone call to place an order with the supply house. But labor costs can vary greatly for an endless number of reasons ranking from a mechanic’s hangover to equipment problems on the job.

Thus, the basic concept is to charge your overhead where it is needed most, and also justified the most. In many instances if you charge overhead on materials, in addition to you normal markup, the result will be to price yourself out of a market or at least a given job. Unless you damage a lot of goods on the job, you’ll almost never take a beating on materials, but you’ll almost always take a beating on excess labor.

The experience of my company over the years has been that we consistently win the low-labor, high-material jobs and lose the high-labor, low material, high risk work in competition with contractors who apply a single overhead percentage to both labor and materials. Year after year, our bottom line has been more than triple the national industry average for our volume bracket, and that’s no coincidence.

It’s long been a rule of thumb in a repair/replacement type of business to double the gross direct labor cost in order to cover overhead and produce a small profit that would be augmented by the profit on materials. This calculation worked fine in its time – which was the good old days of $.30 gasoline and $.10 phone calls. Those days are long gone.

Today’s contractors often find that dollar-per-hour overhead is greater than gross labor cost. Applying all overhead to labor often results in a charge to the customer of anywhere from 2 ¼ to 3 ½ times the total cost of man-hour to the contractor, depending on the type of activity. It’s a way to help recoup your labor losses and make labor a bit less risky.

Have you computed your overhead per man-hour lately? If you have not, the results may surprise you – perhaps even shock you. It is a calculation best computed when you’re sitting down.

Today, unless the sale of material is close to the amount of the sale of labor, and material carries sufficient markup, it’s hard to earn a decent profit. A company doing a lot of high-labor, low-material work is likely to discover at the end of the year that the net profit has fallen well below the goal of 10{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} on sales. “Labor only” work is a loser in the long run.

A word of caution is in order. Using past records and experience to establish profitable selling prices requires careful scrutiny and analysis. Before you establish a standard method for adding overhead and profit, make sure the it will give the most positive results possible. The computer field has an expression call “GIGO,” meaning “Garbage In, Garbage Out,” to illustrate what happens when bad input is programmed into even high-quality computer hardware. If a standard pricing method is based on lousy data, the business you have worked so hard for will end up in the garbage heap!

Worksheet Instructions: The exercises presented in the worksheet attached will dramatically illustrate the benefit of being able to identify overhead not only as a percentage of sales, but also on a dollar-per-hour basis.

The worksheet illustrates four different hypothetical jobs. Important facts to keep in mind are:

1. Direct Cost for all jobs is $1,000.00.
2. Labor cost is $25.00 per hour including fringes.
3. Overhead is 15{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of selling price.
4. Dollar-per-hour overhead is $10.00 per hour.
5. Net profit goal is 10{938cd9e8dae860e800efc538277d4f7684e6f6981618ba70d1c34357a53c2e1f} of selling price.

I have purposefully eliminated various dollar and percentage figures for all four jobs in order to stimulate your “gray matter,” but rest assured you have all the information needed to calculate the answers and fill in the missing blanks. It is necessary to fill in the blank lines to arrive at the selling prices.

You will notice that each job has the same direct cost of $1,000, though with a different ratio between material and labor costs in Jobs 2, 3 and 4. This is significant, and the selling prices will be different in three of the four jobs.

This is important for you to observe, because it will illustrate the difference between the percentage of sales and hourly cost methods of calculating, and between high-labor and low-labor jobs. The point is, it pays to know your overhead on more than one basis, and which technique to apply in a given situation.

These exercises are similar but not exactly the same as the ones I use in presenting my business seminars. I’ve varied the examples so that people who have attended my seminars will have some new problems to figure out, instead of simply showing off how much they remember from earlier lessons.

At the conclusion of my seminars, I ask students which of the sample jobs covered would be most desirable to bid and for what reason. This question generates some very interesting discussion, and I’m sure it will for you too.

So, after completing the worksheet, make sure to choose which of the four jobs in your opinion would be the most desirable one to pursue, and why and how you decided on the project.

Be sure to check out the next addition of The Buzz email for the answers. I will review the correct answers along with a discussion of what it all means. Until then, think of how much you’re worth, and God bless!

Overhead Worksheet