It’s all about accuracy

Cost estimating is all about estimating your costs accurately. Running a profitable green industry business is all about managing your risk successfully. Somewhere and somehow, the two need to intersect. My three-fold mantra for running a profitable business is: price it right, produce it right, produce enough of it. Accomplish these three things consistently and you’ll probably be successful.

Costs come in two forms. First, there are direct costs. These comprise the materials, field labor and burden, trucks and equipment, subcontractor and miscellaneous costs (permits, fees, dumpsters, etc.) that can be directly attributed to a specific job or service. Second are the indirect costs (referred to as general and administrative — G&A — overhead costs) that cannot be directly attributed to a specific job or service. For instance, how do you charge your clients for your electric bill, office manager or rent? Direct costs (except for the number of man-hours needed) are fairly easy to identify and allocate to a job or service. It’s estimating the G&A overhead costs that confuse many contractors.

How it plays out in the field

Harry had purchased and set up a green industry software program. With it he could bid his jobs and track them to see if they were profitable. Like many such software packages, its developers recommended using familiar percentages applied to direct costs in order to allocate G&A overhead costs to bids. Net profit is then added to the totals for each. The familiar percentages added were as follows:

Material costs + 10% + Net profit

Trucks and equipment costs + 25% + Net profit

Subcontractor costs + 5% + Net profit

Field labor with burden + 35% to 95% + Net profit

After using the new software for six months, Harry had me come to his office to review and validate the formulas for G&A overhead and net profit that he was using. We discovered that he had seriously underpriced his work.

Analysis

G&A overhead costs are usually allocated to jobs and services by adding one, two or four percentages applied to the four categories of direct costs (materials, field labor with burden, trucks and equipment and subcontractor costs). This is a faulty mathematical assumption for at least two reasons. First, no one has ever validated (shown that they are correct) any of these percentages, especially the 10%, 25% and 5% applied to materials, trucks and equipment, and subcontractor costs, respectively. Since the percentage applied to field labor is derived from a formula using these three percentages, it is also suspect. Second, as implied by specific percentages and mathematical formulas applied to direct costs, there simply is no such direct correlation as to the amount of G&A overhead caused by direct costs.

For instance, commercial maintenance estimators often double (multiply some direct costs by 200%) field labor + labor burden + materials cost to arrive at a price to charge the client. This may happen to work for certain jobs, but it certainly won’t work for enhancements or installation work. Percentages multiplied by direct costs simply aren’t accurate when it comes to allocating G&A overhead costs to jobs being bid. Let’s discuss the percentages.

The 10% markup

One problem with the 10% figure is what it includes such as filling out purchase orders, receiving and stocking materials, paying vendor invoices, job costing materials cost in jobs, and so forth. It is an accounting nightmare. Perhaps someone, sometime and somewhere has taken the time to do a cost study on this, but I have never met them.

I’ll discuss the 5% and 25% G&A overhead markups on subcontractor and truck and equipment costs, respectively, in my next article. Until then, suffice it to say that these markups are as fictitious as the one on materials. I’ll also explain Harry’s bidding solution and how to work around these markups in a bid if you are using a software program that allocates G&A overhead costs by multiplying direct costs by percentage markups. Meanwhile, if you know of anyone — especially the promoters of software programs using a percentage-based G&A overhead recovery system — who can validate (or says they can validate) any such percentages being used to recover G&A overhead costs, please have them contact this magazine or me. I’d love to hear their explanation and see their data doing so. I contend that it does not exist.