Job costing smackdown

Jim Huston

The primary test of a cost estimating system is whether it calculates your costs – all of your costs – accurately. That may seem painfully obvious but many estimating systems violate this principle. Secondly, cost estimating is a science. As such, all of the formulas and mathematical assumptions in a cost estimating system must be open to verification by independent third parties. Four of the five most commonly used estimating systems within the green industry use percentages (one, two or four of them) multiplied by the direct costs in a job to measure, allocate, recover and control (MARC) general and administrative (G&A) overhead costs. And since G&A overhead costs usually run 25 percent of a company’s sales, these costs are significant and need to be calculated correctly, and accurately included in one’s pricing for projects and/or services.

Unfortunately, all G&A overhead percentage-based estimating systems fail the primary test for an estimating system. They all have serious mathematical flaws when it comes to estimating G&A overhead costs for an installation project or green industry service. Their faulty arithmetic needs to be exposed using the methods of science.

Job Costing “Smack down.” In January of this year, I was one of four discussion panel members invited to respond to audience questions on the subject of job costing. The event was billed as a Job Costing “Smack down” or debate. A pair of boxing gloves adorned the logo for the event. Two of the panelists were landscape contractors and two of us were green industry consultants. Three of the four panelists were either users or proponents of the multiple G&A overhead recovery system (MORS). I was the lone dissenter of MORS and a proponent of the G&A overhead per hour (OPH) estimating system. While the three-to-one ratio may have seemed to be a “stacked” deck, calculating arithmetic correctly is not a democracy. You don’t determine if 2 + 2 = 4 is correct by voting on it.

How do you set up a good job costing system? The first question posed to the panel was (I’m paraphrasing), “How do you set up a job costing system?” The other consultant correctly stated that it all started in estimating. I agreed and added that if your estimating system is faulty, no amount of job costing could correct it. If you are calculating your pricing by materials factoring (multiplying the material costs for a job by a factor of 2.0, 3.0 or whatever), you are automatically making a mathematical mistake that no amount of job costing could make right. You first need to fix the faulty mathematical assumptions.

An estimating system needs to calculate the following general categories of costs accurately: materials, labor hours and labor dollars, labor burden, equipment, subcontractor and G&A overhead. It also needs to calculate a reasonable amount of net profit margin to add to the project or service.

It is through job costing that you collect data, as the project or service is completed, and compare the budgeted amounts for each category to the actual amounts used. If your estimating is accurate, the difference between the two (the variance) will be zero. It is this data collection process that tells you if your estimating system is accurate, your production is on target, and/or if you need to adjust your estimating production rates for future bidding.

Estimating Systems. Four of the six commonly used estimating systems (we’ll cover three) within the green industry use factoring or percentages to measure, allocate, recover and control G&A overhead costs. Factoring is simple multiplication. For instance: 2 x 3 = 6 (the 2 and 3 are factors and six is the product).

Here is how three of the four percentage based systems calculate prices for two different jobs. For ease of arithmetic, we’ll stipulate that our entire field workforce costs $10,000 (with labor burden) per month and our total G&A overhead costs are also $10,000 per month.

• Materials factoring: You multiply the materials in a project by a simple factor.

Job A (a ten month job)

Using a materials factor of 3.0, your price would be $30,000. The GPM is -$90,000…Oops!

Job B (a one month job)

Using a materials factor of 3.0, your price would be $300,000. The GPM is $180,000… Whoopee!! See the problem?

• SORS (the single overhead recovery system): You multiply your total direct costs in a bid by a factor.

Job A

Total Direct Costs
$120,000 x 1.3 = $156,000

Job B

Total Direct Costs
$120,000 x 1.3 = $156,000

Using a SORS factor of 1.3, your price would be $156,000 and the GPM $36,000 for both jobs.

Assuming a 10% net profit margin or $15,600, that leaves $20,400 for G&A overhead for both jobs. But job A requires ten months of G&A overhead ($100,000) verses one month of G&A overhead ($10,000) for job B. The arithmetic in the SORS method is faulty.

• DORS (the dual overhead recovery system): This method applies two different markups to direct costs—one to labor costs and one to material costs. We’ll skip this method as it makes the same mistakes as in the MORS method.
   
• MORS (the multiple overhead recovery system): With the MORS method, you add 5% for G&A overhead to subcontractor costs, 10% to materials and 25% to equipment costs. The labor markup is calculated from the annual budget and the other three percentages. It usually ranges between 35 to 95%. We’ll use 55% but any percentage within this range will illustrate the problem.

Job A

Material costs
$10,000 x 1.1 = $11,000. Add a 10% net profit markup and you get $12,100.

Equipment costs
$10,000 x 1.25 = $12,500. Add a 10% net profit markup and you get $13,750.

Labor costs
$100,000 x 1.55 = $155,000. Add a 10% net profit markup and you get $170,500.

Total price for job A is $196,350. Total G&A overhead on the job is $58,500. MORS understates the G&A overhead by over $41,000.

Job B

Material costs
$100,000 x 1.1 = $110,000. Add a 10% net profit markup and you get $121,000.

Equipment costs
$10,000 x 1.25 = $12,500. Add a 10% net profit markup and you get $13,750.

Labor costs
$10,000 x 1.55 = $15,500. Add a 10% net profit markup and you get $17,050.

Total price for job A is $151,580. Total G&A overhead on the job is $18,000. MORS overstates the G&A overhead by over $8,000.

Final question (Not so final answer)
The final question directed at the panel was, “How do you use job costing to correct and/or adjust your estimating system?” I explained that if your cost estimating system is accurate, job costing helps you to adjust your production rates within a particular bid. However, I added, that if your estimating system is faulty, no amount of job costing will correct it. If you use materials factoring (materials multiplied by 3.0), you’ll never fix the problem with job costing.

I then added, as shown above, that all percentage-based G&A overhead estimating systems have serious mathematical errors embedded in their arithmetic. Materials factoring, SORS, DORS and MORS can get you into serious trouble. Furthermore, the three markup percentages used in MORS by just about all users to mark up direct costs to recover G&A overhead costs (the 5% on subcontractors, the 10 percent on materials and the 25 percent on equipment) have never been scientifically verified by independent third parties. The reason is simple. They cannot be verified.

I guess if you candy-coat materials factoring, SORS, DORS and MORS; you get SMORS. And while candy may taste good, a steady diet of it can harm your physical health…just like factoring used in your estimating system can harm your financial health.