By The Numbers: Handling Overhead

I equate the running of a contracting business to the flying of an F-14 jet fighter through the Grand Canyon. You drop into the canyon at Point A, which is Jan. 2 of any business year. You fly 300 feet above the canyon floor with the walls of the canyon 1,000 feet off each wing. You have to fly in a perfectly staight line to Point B, which is Dec. 31 of that business year. You want to arrive with a profit -- preferably a hefty one.

On the floorboard of your plane are two pedals. You must keep the pedals even with each other. If one pedal gets out of line, the plane will begin to "yaw" and turn into one of the canyon walls.

"So, what are these two pedals in the jet fighter called in my business?" you ask.

One is the amount of overhead you must recover in a business year. The other pedal is the amount of business you must do in a fiscal year to have enough money to recover that overhead and to make a profit besides. Let’s say that your overhead is $100,000. You have determined that you must do $400,000 in sales to recover that overhead and make a profit.

You drop into the canyon on Jan. 2, but by May 15 you see that you are behind your sales goal and that you are not going to do $400,000 in sales. You will be lucky to do $350,000. Your pedals are now out of line. What is your plane doing? It is yawing. And, if it continues to yaw, you will crash your business into one of the walls of the Grand Canyon.

Now, if you were really in the Grand Canyon, and your F-14 plane began to yaw, what would you do in a hurry? You would either push the left pedal forward or let off the right pedal until the pedals lined up perfectly. Do the same with your business. Push the sales pedal forward, or let up on the overhead pedal.

Overhead is a fixed cost. It does not rise and fall based on what you charge for a certain job. You do not need to find out what others charge for overhead and charge the same. Overhead is not charged, it is recovered. And you do not make any profit until you recover your overhead. To do this you must budget overhead, spend on overhead within that budget, allocate overhead properly and recover it.

I know a landscape construction company that has an accountant who is very nice, except on Jan. 2. She comes in half an hour before everyone else on this day and, with a wicked grin on her face, she turns on her computer and puts an invoice into the printer. She prints out a bill to the management of that company for the amount of overhead the company must recover in that business year and leaves a copy on each person’s desk.

When the staff comes in reeling from New Year’s Eve festivities and football, they are faced with that invoice. They must realize quickly that their plane has taken off and is descending into the Grand Canyon. They know they’d better keep their pedals even so they can arrive safely at the other end of the canyon on Dec. 31 -- with a profit. The staff knows where they stand and that they had better go out that year and get enough work with enough overhead allocated on it to recover that overhead and to make a profit.

I recommend that contractors keep track of the number of overhead dollars that must be recovered in a year in a computer spreadsheet program or on a piece of paper. Every time you sign a contract for a new job, subtract the amount of overhead you have built into that bid from the year’s total. Make sure that within a business year, you do enough work to bring the overhead dollar figure down to zero.

The staff of the landscape construction company with the good accountant does not even talk about profit from January through mid-November because they consider that there is none. Any money collected above what it costs to do a job goes to pay overhead. The accountant keeps track and when the overhead is recovered, she puts a copy of the original invoice on everyone’s desk stamped "Paid in Full." At that point, they have a party -- A Break-Even Party. Right after the party, they put the pedal to the metal, because everything else they collect over costs for the rest of the year will be the company’s profit for the year.

PROFITABLE LOSSES. Here is a point contractors must understand: You can make money on every job you perform, but lose money as a contractor for that year. Some contractors do not understand what job costing really is. Job costing takes the original estimate of costs to do a job and compares it with the actual costs to do the job. This is done at the level of costs: This is why it’s called job costing. Some contractors take their job costing to another level. They add overhead to costs and subtract costs with overhead from the contract amount to see if they have made a profit. That is no longer job costing, it is generating a financial statement or a profit-and-loss statement on each job.

Now, I don’t mind if a contractor does that, but he or she must understand the basic principle of job costing. You see, each of those financial statements on individual jobs is a just snapshot. The company and its profitability are a mural made up of those pictures. Individual pictures may look pretty good, but the company mural can look real ugly. Why would it look ugly? Because there are not enough pictures in that mural with enough overhead allocated in them to cover the company’s entire overhead. This is why you can make money on every job you perform, but still lose money as a contractor.

Why not just add more overhead to the work the company is getting? Because there is a fine line of the right amount of overhead that can be charged on a job depending on the kind of company doing certain kinds of work in certain areas. The goal for each company is to find the fine line that both gets you work and recovers your overhead.

For now, think of it this way: Contractors actually make all of their profit in four to six weeks. From January through mid-November, they are just recovering overhead. Sometime in mid-November, they start making profit -- everything they do in the last four to six weeks of the year is their profit for that year.

I had a contractor call me just before Christmas one year. I think he waited until then on purpose. His company had broken even the first of October, which left them eight weeks into their business year. He said that they billed more work during those eight weeks then any other eight-week period the whole year and drove the profit into the high six figures.

I always get a sick feeling in autumn and around the holidays -- and it’s not because of the holiday goodies. First, there is hunting season. Then they are playing Christmas music down at the mall. It’s the holiday season and contractors put their planes on autopilot. At the very time they are making a profit, they slow their efforts. I get sick when I think of all the tens of thousands of contractors who have worked very hard to recover their overhead and are finally making a profit, but who coast out the business year just when they could be getting ahead. Remember this next year when you’re flying through October toward Dec. 31!

The author is president of Vander Kooi & Associates, Littleton, Colo. He can be reached at 303/697-6467.