Overhead And Profit

ruskent

Dirt explain to us how knowing how to be profitable is more important then good estimating. Because as far as i am concerned, good estimating leads to profitabilty. A good estimator will estimate base on the companys production speed, overhead, and profit requirements.

Jerrald Hayes

Late last week and over the weekend I received a couple of emails from some folks who were reading what I think was this discussion here on CT asking me for clarification on some of the things I written and asked me to speak up regarding debate between using a Capacity Based Markup vs. a markup strategy that is based on predicting your yearly total dollar (labor, materials and subcontracting) sales volume (i.e. a Uniform Percentage Markup) .

While I think the markup methodology described in the book Markup & Profit is better than no methodology at all there are some real big huge problems with it that especially in the tight competitive market like we are in today could cause a contractor a lot of financial problems.

In his book Running a Successful Construction Company writes about markup in Chapter 5 Estimating and Bidding on pgs 167 through 168 and in two sidebar blocks on pg. 167 writes specifically about the danger of using a Uniform Percentage Markup: The Google Books Excerpt.

I've also written about this twice in my own blog in "One of the Potential Problems in Using a Traditional Volume Based Markup" and more recently "Comparing Markup Methodologies In Real Some World Pricing Scenarios" where I illustrated scenarios which show how contractors using Uniform Percentage Markup will find themselves underpriced and will lose money on jobs where there is a 'High Relative Cost of Labor to Low Cost of Materials, and SubContracting' and will find themselves overpriced and priced out of the market on jobs where there is a 'Low Relative Cost of Labor to High Cost of Materials, and SubContracting'.

While I think Michael Stones book is generally a good book every contractor should have on their shelf I think Gerstel's book and Ellen Rohr's book How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love provide far better safer and more robust guidance regarding markup.

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Jerrald Hayes About ParadigmProjects.com

Jerrald Hayes

T. D. G. I've looked at the numbers you've published in your initial post here and I now have a couple questions for you before I give you my take on this.

$20,500 a year (or $1708.33 per month) while realistically possible for a one person operation sounds a little on the light side to me. Just what do you consider to be your overhead costs? I am thinking I can infer from your comment. "I know what profit is, but how much to charge on each project bid." that you have not included any Net Profit in that calculation.

That said going on the assumption that that number is the correct figure for your business I would then take that number and divide it by 50 to come up with a weekly overhead allocation number you need make. I divide by 50 rather than 52 figuring as DavidC did that you will want to take off from work a least 2 weeks of time over the course of a year and come up with a figure of $410.

Now taking the next step looking at your your estimated labor costs for this 2 week project I'm wondering just what does that $7,000 figure represent? Is that one company employee working two weeks (80 hours) at a stratospheric COST of $87.50 per hour or is that three employees working for two weeks at a perhaps more realistic COST of $29.16 per hour.

The reason I ask that is because I have seen contractors in other forums develop a Capacity Based markup Loaded Labor rate (which is a labor rate that takes into consideration, an is thereby "loaded with" all the Variable Overhead and Fixed Overhead costs and Net Profit associated with a unit of labor. I.e. wage/salary + benefits + overhead costs + profit margin) and then multiply that figure by 1.5 Uniform Markup multiplier they're read about in Michael Stones book which essentially has them double dipping for their overhead and profit and they come up with a ridiculously high figure which of course would be rejected.

I am going to assume your labor figure represents something more like the three employees working for two weeks at a cost of $29.16 per hour or even two employees working for two weeks at a cost of $43.75 per hour. Given the wide disparity of labor costs nationwide both those scenarios are potentially realistic depending upon what part of the country you are talking about.

Actually all my labor cost figure questions are something of a moot point. If the job took two weeks of your company's time you need to charge two weeks of overhead costs to it. Period. 2 x $410 = $820.

So Labor Cost of $7,000 + Company Overhead Charges of $820 + Materials Costs of $10,000 = $17,820 (but as I said before that Overhead figure sounds a little weak to me).

That said however none of figuring so far that includes anything for Net Profit which is the dollars you want left over after every single thing, job costs and overhead are paid for. How much Net Profit you want to make is really something of a subjective number. How much do you want to make? In figuring your target for Net Profit keep in mind that while Uncle Sam allows you to deduct a lot of your costs of doing business this is the figure he takes his cut out of. So when you figure for what you want to make above and beyond the wage and/or salary you pay yourself you need to figure for his cut too.

So while what is an acceptable amount of Net Profit to make is a worthwhile discussion in its own right there are basically two ways of approaching how to look at it. You can figure a target as a percentage Return on Equity or you can target a percentage of your total volume.

I like and often refer to George Hedley's take on the subject which is about your Return on Equity: How Much Profit Is Enough. In it Hedley writes:

Working with Hedley's ROE thinking let's say you have a modest $60,000 worth or Equity in your business. 20% of that works out to a desired $12,000 return on your equity which divided by 50 weeks equals $240 per week. Times the 2 weeks you expect your project to take that adds on $480 for a total project cost of $18,300.

On the other hand on pg. 186 of his book Markup & Profit: A Contractor’s Guide Michael Stone says "You should be making a minimum of 8 percent net profit" " but there’s really no reasoning or discussion on it beyond that sentence. And I feel I can safely say he is referring to 8 percent of your total volume. That just seems way too low a target for any almost any kind of business. Sure there are some mega huge high volume contractors who work with even smaller percentages than that but (and I really hate to say this) they do make it up on volume. Besides if you target 8 percent you will probably hit on 4 or 5 and actually only pocket 1.5 to 3.5 after Uncle same takes his cut.

Conservatively thinking I think a target in the range of 10-15% is a far better idea. Ellen Rohr recommends 20%, and while Gerstel never actually recommends a target Net Profit percentage in an example he uses on pg. 95 the company he citing earns a 14.28% Net Profit. Gerstel does however talk about a number of key ratios to look at towards the end of Chapter 3 Going Deeper into Your Numbers to evaluate how well you company is doing with its Net Profit earnings.

Still this is where the quality in the mind of your customer of the service product your company delivers is critical. The better they view your company the higher Net Profit you can call for and achieve. I think most contractors just getting started with an estimating and pricing system should shoot for a Net Profit in the range of 10-15%.

For what its worth though I think there is a far simpler way to deploy a Capacity Based markup strategy than having to go through the mathematical gyrations I just described here with each and every project.

Sit down and develop loaded labor rates for you and all your employees have your overhead costs and Net Profit on your company's labor built into it based on the methods described in Ellen Rohr's book and/or google the Capacity Based Markup Worksheet use that as a guide.

Then estimate the number of labor hours the tasks in your project will take and multiply the hours for those tasks by the loaded labor rate for the personnel you expect to have doing the work.

Then add an appropriate contingency buffer of hours to protect the whole project from what you might be off in your task hours estimating and multiply that by your median or average loaded labor rate. Its a whole other discussion but you don't pad the individual tasks with contingencies since it is unlikely that every task will run as a worst case estimate and padding for that would unnecessarily bloat your time estimates and labor cost quote.

Then with regard to your materials and subcontracting assuming you have included the time involved in acquisition and delivery of the materials and supervision of the subs into your company's labor estimate I would add a percentage to each of those cost figures that I would want to have my company earn as a Net Profit for "selling" those products (the materials) and services (the subcontracting) to my customer.

Keep in mind however that if you lets say want to earn a 10% Net Profit on your Materials you can't just add on 10% (multiply by 1.1). That will only earn you a 9.1% net profit. You'll need to multiply by 1.11 to earn a 9.9% Net profit (and I think that's close enough). See the list below for typical Net Profit Markups

A 1.07 markup will return a Net Profit of 6.5%
A 1.08 markup will return a Net Profit of 7.4%
A 1.09 markup will return a Net Profit of 8.3%
A 1.10 markup will return a Net Profit of 9.1%
A 1.11 markup will return a Net Profit of 9.9%
A 1.12 markup will return a Net Profit of 10.7%
A 1.13 markup will return a Net Profit of 11.5%
A 1.14 markup will return a Net Profit of 12.3%
A 1.15 markup will return a Net Profit of 13%
A 1.16 markup will return a Net Profit of 13.8%
A 1.17 markup will return a Net Profit of 14.5%
A 1.18 markup will return a Net Profit of 15.3%
A 1.19 markup will return a Net Profit of 16%
A 1.20 markup will return a Net Profit of 16.7%
A 1.21 markup will return a Net Profit of 17.4%
A 1.22 markup will return a Net Profit of 18.%
A 1.23 markup will return a Net Profit of 18.7%
A 1.24 markup will return a Net Profit of 19.4%
A 1.25 markup will return a Net Profit of 20%

While I generally recommend against doing T&M work when you can give lump sums using this method you then at least have a loaded labor rate in place that you can quote and apply to any "extra" change order work you elect to or get called to do on a T&M basis.

So summarizing what I just said...you are essentially working with a selling price equation that looks like this:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x NetProfit_Markup) +(SubContractor Costs x NetProfit_Markup) = Selling Price.

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Jerrald Hayes About ParadigmProjects.com

Jerrald Hayes

Malice? I'm not really sure just what you meant by that. Were you aware of the problems the problems with the Uniform Percentage model that Gerstel illustrated in his book and that I've written about?

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Jerrald Hayes About ParadigmProjects.com

Jerrald Hayes

While I think your general thinking and intent are correct for a one person company I think 2000 per person sounds a little bit high. The best companies that run like tops that I've seen generally have employees that generate around 1600-1700 billable hours and it is not all uncommon to see service companies like plumbers, electricians, and mechanical contractors at around 1200. Their even lower billable hour ratio is often due to their having their employees starting and ending up at the shop each day which are typically non-billable hours. Electrical plumbing and mechanical contractors working large projects where they can have their employees start out and end their day on the worksite each day and clock in eight hours there typically have ratios more in line the carpentry contractors that can generate around 1600-1700 billable hours.

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Jerrald Hayes About ParadigmProjects.com

Jerrald Hayes

I'm wondering that too but I never seen any kind of correlation between material costs and job size as I seem to think you might be alluding too when you wrote: or am I missing your point that you are trying to make about something else?

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Jerrald Hayes About ParadigmProjects.com

rbsremodeling

Yes and I think you and Mr Gerstel make good points.

I think Of Michael Stones book and Mark up software basic construction math and a foundation for guys to start the process of thinking .

His method is simple and easy to implement for most. I have always thought small steps for most were best.

Malice: desire to cause injury, pain or distress.

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rbsremodeling

Agreed, while I factor 2000 billable hours of work performed by my guys, 1500-1600 are job site tasks the other 400-500 are considered Jobsite management costs

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MattCoops

I vote this as best post for 2008.

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Matt with Cupan Custom Tile & Paint of Lowell, Massachusetts
Design and installation of ceramic tile and natural stone for floor, wall, and countertops
(978) 601-8774 | cupantile@gmail.com | view tile pictures and more

Jerrald Hayes

Thanks for your very quick reply RBS but a Uniform Percentage Markup isn't any simpler or easier than a Capacity Based one and I can in fact argue that it is a lot more complicated to work with in real practice.

Case in point (and this is only the first test case) lets say based on your 2007 costs which were 28% your own company's labor, 42% materials and 30% subcontractors you have figured out the Uniform Percentage Markup you need to use for your company is 1.55 (or any other hypothetical figure you want it to be for that matter).

Now the fellow that owns the lumber yard you get all you material from tells you he wants to hire you and your crew to supervise construction and perform the carpentry for him a new home he's building for himself only since he owns a lumber yard he is going to provide all the materials for the project. How do you go about adjusting your markup to make up for the 42% gross profit shortfall you will have not supplying the materials while you are working on that project?

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Jerrald Hayes About ParadigmProjects.com

DavidC

As I've stated before, M. Stone's book got us pointed in the right direction and greatly improved our bottom line. Later, after reading Jerralds method, we did duo estimates for awhile using both methods.

The end results were nearly the same when we supplied all materials. The bottom line cost to the client was very close. In instances where the customer supplied materials we took a hit with the volume based method. The capacity based method negated the effect.

We currently load the labor rate for all overhead recoupment, marking up both labor and materials for our profit goals. Thank you for that Jerrald Hayes.

Good Luck
Dave

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www.CookContractingLLC.com

ruskent

I was taught that it is bad to use material markup to recover overhead.


I recover all overhead through my hourly labor rate.

rbsremodeling

This is where material allowances and a bit of thinking it through helps.

When I estimate a job and lets sat its 50K priced out

IF materials are lets say 15k cost. IF the homeowner wants to supply materials or anything else the cost of that item is subtracted not the price/overhead.

So my overhead is still included in the contract even for the items supplied by the homeowner.

With me they save absolutely nothing by purchasing material on their own in fact it always cost them more time, money and usually some aggravation. If they buy it it is their responsibility for it and I charge to correct problems that arise if it is wrong. Even if it is just going and swapping it out for the right part or picking it up for them.

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rbsremodeling

By removing the cost of the items from my estimate and not my overhead/mark up on that item, the markup still remains in the estimate.

That is why you don't give anyone estimates with breakdowns but allowances for items that need to be decided on or picked out.

I always price out full labor,material and sub pricing in estimates if something is removed it is the cost of the item the overhead still remains in the fee. overhead and profit does not change because materials are remove or supplied

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ProWallGuy

Excellent thread! I just rated it 5 stars.

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Wallpaper Hanger St. Louis
Digital Murals Installation

DavidC

Just posting because I saw my post count and wanted to change it.

Good Luck
Dave

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www.CookContractingLLC.com

Jerrald Hayes

I've got a couple of questions for you RBS (that's a euphemism for "challenges" or "things we can debate") but I am headed out the door to the Apple store and then off to a Cold Fusion users group meeting. But I will leave you with one question that I think is apropos given that I'll be at a programmers meeting tonight. I can't think of a computer estimating program or even a simple spreadsheet that easily and conveniently allows you to do what you've just described. From a programers perspective (I develop applications in FileMaker, Cold Fusion, and Excel/Numbers) it can be done but it's jumping through hoops to support a bad methodology. In other words why do it to support a financially flawed method....And for the life of me I can't think of any program that accommodates that technique you've just described. How are you doing that?

Well in my contracting company we will give breakdowns of costs to our prospective clients but we never breakout our overhead and profit. We've always done as William Asdal recommends in his excellent book Defensive Estimating: Protecting Your Profit....we "Use Retail Pricing at Every Line". Breaking out overhead & profit doesn't help clients make the decisions they need to make in planning their projects. It only confuses and obfuscates the issues. When you go into an Apple store you don't get a breakdown on the materials, labor,overhead and profit that Apple calculates into the price of their products. You look at the machine and decide one way or another whether a 24: iMac is worth $1,799.

I'll talk with you again tomorrow I hope.

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Jerrald Hayes About ParadigmProjects.com

rbsremodeling

Jerrald

I will try to get a couple of screen shots from my software to show how it is done.

I love debates so I do not mind the questions or giving answers. I have an extreme thirst for knowledge and love good arguements/conversations, so I look forward to it and I hope it turns into a learning experience for me and others as well.

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orson

Where are you guys getting 2000 hours?

The following holidays put us at 3 days: labor day, independance day, and memorial day.

Now you have potential holidays: Christmas, New Year's Day, Thanksgiving, Easter

Add to that the first one or two days of hunting season.

Now tack on a minimum 1 week's vacation.

Don't your guys ever get sick or have a dentist's appointment?

I personaly think using 2000 hours is unrealistic.

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Kitchen & Bath Remodeling PA- Bathroom Remodeling Lancaster PA
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rbsremodeling

40 hours x 50 weeks == It is unrealistic. At least production wise it is impossible. My guys work about 1400-1600 actual production hours and I a lot 400-500 hours as management time.

For me that amounts to about 120k in management fees for them. That is off the top of my head so it may be more or less

Who pays for the vacation time, Christmas, thanksgiving time etc????????????

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