By The Numbers: Controlling Overhead

As I said, this cost structure is tell-tale of a maintenance or pure service organization. Examples of this type of concern might be one practicing interior maintenance, exterior maintenance, irrigation service, tree care, lawn care or design services.

Because the cost structure is so predominantly labor and overhead oriented, it serves no real purpose to get fancy with some esoteric method of overhead recovery. My personal preference is to keep it simple and recover overhead as a function of labor. To do this, simply divide overhead by the combination of direct labor and labor burden. The quotient of this formula is the percent markup you would apply to the combination of labor and burden in your job estimate to recoup your overhead.

Therefore, were you to estimate a job by first determining your direct costs and then applying overhead, you would multiply the sum of total direct labor plus labor burden by 140 percent. This will calculate a pro rata amount of overhead to be applied. Add direct costs and overhead together to determine your breakeven point, and then add the net profit percentage of your choice.

Whenever I am figuring overhead as a function of labor, I always like to test my calculation to make sure that it makes logical sense. The way I do this is to price one hour of labor. Consider the following givens: the composite wage rate I use in estimating jobs is $7.30 per hour; I have figured labor burden at 20 percent of labor (remember, labor burden is the payroll tax and insurance that is a specific function of labor); overhead has been calculated at 140 percent of labor and labor burden; and I would like to earn a 10 percent profit.

Note, however, that one of the reasons this selling rate for labor is so high is because of what we have lumped into overhead. In a green industry company that is very labor intense, the chances are good that included in overhead is a large sum of money devoted to the ownership and operating cost of equipment.

In the above example of determining the selling price of one hour of labor, I would hazard a reasonable guess that included in the $12.26 per hour figure for overhead is about $5.00 for equipment. If you wanted, you could isolate that equipment portion of your overhead and charge it to jobs only when you use equipment. This would lower the price you would need to charge per hour for your labor and establish hourly rates to be charged for the use of equipment as your jobs required. Calculated correctly, you should mathematically end up in the same place at year end, regardless of what system you use.

The difference arises on a job-by-job basis. By isolating equipment so it is charged to jobs only when you use it, you will lower your price on less equipment-intense work, theoretically making you more competitive, and raise your price on heavy equipment jobs, thereby making your pricing more representative of what it costs to perform the work. If you are set up to handle the details and the paperwork, my personal preference is to unbundle equipment from overhead and charge it on an as used basis. This is not a critical issue, but it could be useful in fine tuning your competitiveness on certain jobs.

MAKING IT ON MARKUP. What about the company that sells both material and labor, such as any installation contractor?

An all-material markup won’t work because of the weightiness of the overhead, which supports labor. The all-labor markup isn’t satisfactory either as, in an installation environment, a good portion of the overhead structure supports the expediting process of the material. And the markup on total direct costs doesn’t get it because, while this method marks up both labor and material, the markup assumes that overhead supports material and labor equally, which is not correct.

Both labor and material require a markup, but because so much of my overhead is in support of labor, I know the markup there must be a greater percentage than on material. What I’m saying is that in an installation company I am in need of two markups for overhead – one on labor and burden and one on material.

In an installation company, direct costs consist of large portions of material and labor, costs that we are selling to our clients. Overhead in an installation company is also rather substantial and is, in great part, devoted to the support of the material and labor we are selling. In a perfect world, it would be ideal if we could actually segregate the overhead that supports labor in a labor column and the overhead that supports material in a material column. Then we could total each column of overhead and calculate the percentage of each column to its respective labor or material cost. In a literal sense, this is what we could do if we chose not to use the dual rate formulae.

What this does is take the two major exposures we sell in our work – labor and materials – and allocate each overhead account to the exposure that is principally responsible for creating it. We end up seeing that labor is principally responsible for the existence of the indirect overhead expenses, which is logical because the biggest account listed in indirect overhead is indirect labor, or the non-billable portion of our payroll. Equipment overhead expenses are also unbalanced in support of labor. This stands to reason in that to perform its work efficiently, labor must use the latest innovations possible in the equipment arena. Expediting material does require some equipment, but that support only calls for about one-third of the division’s total dollars spent in the equipment categories.

So what does all of this tell us? Well, if every year we do a budget by division and every year we allocate the overhead accounts into columns indicating the direct cost accounts they support, then we can figure how to recover overhead as a function of what created it. If accuracy is what we are looking for, this is utopia.

Using an example where total labor and burden is responsible for recovering $111,022 of our overhead and total material has to recoup the remaining $67,577, we can create two markups – one for labor and one for material – that would apply a correct amount of overhead to a job, regardless of the mix of material and labor on that job. When labor is incurred, we would apply a certain percent of labor overhead to that job, and the same is true with material.

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If I am budgeting total labor and burden of $88,662, then I can figure what kind of markup I need on my jobs for labor by dividing the overhead created by labor, $111,022, by my labor and burden budget.

Similarly, if I am budgeting the total direct material costs for the coming year to be $161,358 and I want to recover the overhead costs associted with that material, I will follow the same procedure.

We have just created our own dual overhead markup system so that no matter the mix of material and labor on the job, we can be sure of applying the correct amount of overhead – a markup of 41.88 percent on every dollar of material and 125.22percent on every dollar of labor. For an installation company or a company with a large value of both material and labor to sell, this philosophy makes great sense and, from my view, would be hard to improve upon.

The author is an industry consultant with Ross-Payne & Associates, Barrington, Ill. He can be reached at 847/381-8939.