Averages can kill you

Did you hear about the six-feet-tall man who drowned in a lake that, on average, was only three-feet deep? If you’re not careful, relying on averages can be harmful to your health – your business health. Averages are useful under certain normal circumstances. However, when circumstances are no longer normal, the averages more than likely no longer apply and you have to make adjustments.

How it works out. A commercial landscape contractor in New England projected his field truck and equipment (T&E) costs for the year at $800,000. He projected his billable field-labor man-hours at 80,000. He’d divide the costs by the man-hours and get $10 average T&E cost per man-hour.

$800,000 ÷ 80,000 = $10.00 “average” T&E cost per man-hour

He’d add $10.00 of T&E costs to every man-hour included in his bids. The year before I worked with this contractor, this faulty mathematical assumption cost him $500,000 in unallocated equipment costs. Shortly thereafter, it cost him his company.

A general manager of a residential landscape design/build company in Utah insisted that he should put all of his field trucks and equipment costs in his general and administrative overhead and allocate it to jobs by applying a 50% gross profit margin in his bids to his field labor and materials cost – essentially doubling them. Subcontractor costs were marked up separately. Over the next few years, the owner of the company noticed that his net profit margins were steadily declining but he didn’t know why.

A full-service landscape contractor in California was pricing his work using the Dual Overhead Recovery System (DORS) method where he marked up his materials by 1% and his labor by another. Costs for his trucks and field equipment were included in his markups.

However, during the peak of the last recession when he really needed to sharpen his pencil to get any work, he wasn’t being competitive or getting any work. He was in a quandary as to what to do.

Analysis. All three of these contractors were essentially making the same mistake. They had a false mathematical assumption in their cost estimating systems. They were averaging their truck and field equipment costs in their bids. The New England contractor would estimate his equipment costs for a job with 1,000 man-hours in it at $10,000 (1,000 MHrs x $10.00 per MHr). A job with 1,000 man-hours that required just pickup trucks and wheel barrows would only need about $4.00 per man-hour, so he’d over-estimate his equipment costs by $6,000 (1,000 MHrs x $6.00). He wouldn’t win these bids. Jobs that required all of his equipment (trenchers, skid steers, mini-excavators, etc.) and should have bid with $15.00 of equipment per MHr, he’d under-price. Guess which jobs he’d win? The more work he did, the less money he’d make. He eventually went out of business.

The Utah contractor realized that his 50% GPM (with all of his truck and equipment costs in it) over-priced some jobs, underpriced others, and occasionally was right on. He realized his mistake, corrected his estimating system and fired his GM. He’s doing well today.

The DORS contractor also realized that he had a mathematical flaw in his estimating system. He needed to put equipment costs into his bids as the job required. Some jobs needed lots of equipment costs in them, while others needed much less. Including his truck and equipment costs in his DORS G&A overhead markups just wasn’t accurate.

Conclusion. Imagine if your state passed a law mandating that all hotels charge $100 per night per room – no higher and no lower. Where would you stay? You (and I) would stay at the most expensive hotel that we could find, the one that was underpriced. We’d do so because we’re not stupid. Your customers aren’t stupid either. If you are foolish enough to underprice your work, you’re going to get lots of work. Averaging a direct cost such as your trucks and field equipment costs can get you into a lot of trouble. The solution is accurately calculating the costs for your trucks and field equipment as needed for each and every job.

Averages killed the man in the lake because he got in over his head. Don’t get in over your head by including your truck and field equipment costs in your “overhead” – that is your G&A overhead. L&L

Contact Jim Huston at jhuston@giemedia.com