Use Overhead-Cost-Per-Hour, Not Just Gross Margins for Measuring Profitability
Originally published: 05.01.11 by Ruth King
Without considering overhead, results will be skewed.
In traditional pricing calculations, residential contractors are taught to determine their service rates and replacement selling prices based on gross margins. I have found that this method can be a disservice to the contractor for many reasons. First, gross margin doesn’t tell the whole story. It covers only the direct costs for the job. It doesn’t consider what the overhead costs were. Second, gross margin is a percentage — it is not actual dollars. You cannot take a percentage to the bank; but you can take dollars to the bank.
One of the things I do when I begin working with contractors is to determine their overhead-cost-per-hour. Then I take 20 actual jobs and see whether those jobs were actually profitable. I’ve seen 60%-gross margin jobs that actually lost money when overhead is included in the equation. I’ve seen 20%-gross margin jobs that earned a profit when overhead is considered.
The key to successful pricing is to know your company’s overhead-cost-per-hour. For smaller companies, determine the company’s overhead-cost-per-hour. For larger companies that departmentalize financial statements, determine an overhead-cost-per-hour for each department. You know that you should departmentalize by department if your field labor usually works in only one area. There may be times that labor crosses over, especially in slower times of the year. However, most of the time, a field employee is identified as being in X department. (When you review your financial statements at the end of the first fiscal year of calculating overhead-cost-per-hour, you probably will refine the costs per hour for each department. You’ll get more and more accurate as the years go by.)
Here’s another reason for knowing your company’s overhead-cost-per-hour: Assume that your company’s overhead cost is $50 per hour, and your competitor’s is $25 per hour. For every eight-hour job, your overhead cost is $400, and your competitor’s cost is $200. He can do a job for $200 less than you can and make the same profit!
If your selling prices are similar, then your competitor is earning $200 more on the job than you are. Either way, your costs are much higher than your competition. You want to be as productive as possible, and you can’t do that with gross margin pricing calculations.
From a service perspective, assume that your service technician charges Mrs. Jones $300, and was on the job three hours. You set the service department gross margin at 50%. You calculate your service department’s overhead-cost-per-hour at $60. The gross profit of the job is $300 X 50% or $150. Your gross-profit-per-hour is $150 divided by three hours. This means your gross profit per hour is $50. Your overhead-cost-per-hour is $60 so you actually lost $10 per hour, or $30 on that service call.
Understanding your overhead-cost-per-hour and gross-profit-per-hour is critical. Not understanding this is how you can achieve a gross margin of even 50% and still lose money on a job.
How to Calculate Overhead-cost-per-hour
For smaller companies, to calculate your company’s overhead-cost-per-hour, use your total company overhead and total field hours. Divide your total overhead last year by the total number of productive hours (that is, revenue-generating hours). Use only the hours that your field employees actually worked for customers. Cleaning the shop, training hours, meeting hours, vacations, holidays, and sick days don’t count in this equation.
If you have departmentalized, then do the same calculation as described above except for the overhead for each department. You’re likely to find one department has a much lower overhead-cost-per-hour than another. At this point, you know how little you can charge a customer in slower times of the year and still make a profit on an individual job.
The result can be very sobering. It’s common for me to find this number above $60 per hour. The idea is to identify it, get it down to a reasonable number, and compete!
Reducing Overhead Costs
You can keep overhead costs in check by having as many revenue-producing hours as possible. Sometimes it is as simple as sending the men to the jobs from their homes rather than coming to the shop. Other times it is streamlining dispatch and/or getting job material sheets so that materials can be pulled, and the employees don’t spend time pulling their own jobs. Another way is to keep the technicians and installers working on jobs rather than having them stop to go to a parts house.
One of the best ways to reduce overhead costs is to ask your employees for ideas. They know how they waste time. Many times you have to ask the office about the field and vice versa. Implement their suggestions.
The comment, “I can’t do anything in slower times of the year,” doesn’t fly either. I know a contractor in the South who almost never lost money in the traditional slower months. I asked him how he achieved this profit because most contractors can’t. His answer was that he had no choice. He didn’t have the cash saved in the early years to lose money in any month. Then, as the business grew, it just became a habit. He was extremely proactive in slower months, knocking on doors, calling customers, and offering specials. Since he knew what his overhead-cost-per-hour was and what revenues he needed to generate each month, he knew the exact lower price he could offer a customer for purchasing “now” rather than when the company got busy.
Generally, the first time you do this allocation, your estimates will be just that, estimates. In a few months everyone will be conscious of the amount of time spent in each department, and the percentages will get more accurate.
Guidelines For Overhead Per Hour
Department managers must realize that as their department expands, it’s going to be assigned a bigger share of the overhead simply because of its growth. I’ve worked with many companies that start out with small service departments, but then I’ve helped them grow. Initially the service department overhead percentages are small, and the actual overhead expenses are little compared with the other departments. Once the service department grows, the overhead percentage gets bigger, and finally the service department says to me “I don’t want to pay that much overhead.” Unfortunately increasing overhead is a fact of life when a department grows.
Many times the departmentalization calculations are eye opening for managers because for the first time they have to look at the productivity of each office employee. When they realize that their department must pay a portion of that person’s salary and benefits, they sometimes speak up saying, “That person isn’t productive, and I shouldn’t have to pay for him or her.”
The issues always revolve around what is fair. I often get asked, “Why don’t you departmentalize by sales?” The simplest answer is that $1 million in new construction sales takes a lot less overhead than $1 million in service sales. Each department must take its fair share of the overhead expense.
What should the overhead-cost-per-hour number be? Less than $20 per hour for new construction, and less than $30 per hour for service/replacement. These are averages. If you are starting up a department with only one or two people, these numbers may be higher. If you have a department with 25 productive people, these numbers may be lower.
Relying only on gross margins to determine whether a job went well or not is dangerous. You have to know and understand what your overhead-cost-per-hour is. The only thing that really counts is the net-profit-per hour that you are generating. That’s what you can convert to cash and take to the bank.
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