Business Benchmarking: Overhead Overview
authors Kyle Clapham
To price a job correctly, remodelers need to cover the cost of completing the project but also pay for operational expenses and fulfill their desired net profit. Expenses, or overhead, keep the business running no matter how many jobs the company sells and, thus, do not apply to any single project. Once remodelers comprehend their overhead, they can calculate their proper margin and markup.
“You really can’t figure out what your pricing strategy is until you know your overhead,” says Alan Hanbury, co-owner of House of Hanbury Builders in Newington, Connecticut. “Any other choice of markup or margin that you pick without knowing your overhead is just a guess at best.”
Many remodelers mistakenly classify direct costs as overhead and, therefore, do not charge enough for each job to cover their operational expenses. If they had accounted for all the direct costs before determining the sales price of a project, they could have marked up the actual cost to produce the job and ensured the resulting sales price covered their overhead as well as their anticipated net profit.
“The more they understand overhead, the more they understand the true cost of business, and then they can develop a sales price accordingly,” explains Victoria Downing, president of Remodelers Advantage, a group dedicated to helping remodeling contractors achieve professional success.
Some expenses, such as production managers and sales commissions, generate debate within the industry because they could fall reasonably into either bucket. If remodelers include these items in overhead, they must continually revisit their budget as they sell more jobs—or hire non-field production workers. Otherwise remodelers just need to make sure they can close contracts at a higher sales price to cover the increase in direct costs.
“We want as many things in cost of goods sold as we can, so that we mark them up and have the client give us a legitimate markup to pay for our overhead,” says Hanbury, who points out that incorporating all the labor burden items of field workers—including the field time of production managers and sales commissions—as direct costs also gives remodelers a more accurate sense of the true cost to run and perform jobs.
A detailed chart of accounts, moreover, enables a remodeler to track each job cost and overhead expense as they accrue during the year. Grouping together related expenses—for example, sales and marketing—allows the company to look at subcategories of overhead and compare amounts with previous periods to evaluate whether an expense has become a larger portion of the budget.
Remodelers also should establish an extra column in their chart of accounts that expresses each overhead expense as a percentage of sales. Sales volume varies greatly among companies in the industry, so measuring expenses as a percentage of sales volume permits reasonable comparisons.
“Anything you wanted to manage you would have an account for it, but you’d want it to be in a group so you could just look at the subtotals of those five or six items,” Hanbury says. “And then each month you can look at the percentage that goes with it, and see if it’s tracking much higher than it was before or about the same, without having to memorize what every dollar amount should be.”
Overhead pays the wages and benefits of employees who work in the office, such as receptionists and salespeople, but not for company staff on the jobsite. Insurances and taxes that must be paid on employees—for example, workers’ compensation—belong in overhead only when they apply to staff not in the field; for employees on the jobsite, these items need to be figured into labor rates when estimating the direct costs.
Remodeling business owners often fail to include a salary for themselves in overhead that indicates their value to the company. Some remodelers intentionally enter a low number, usually on advice from their accountant, because claiming less W-2 income helps keep their taxes down, Hanbury explains. The IRS, however, frowns on business owners who earn a salary lower than their highest-paid employee, he adds.
“They need to be paid in overhead first if they don’t work in the field,” says Shawn McCadden, remodeling industry consultant and owner of Remodel My Business. “They need to be paid for what they do to run the business, and then the net profit is the return on their investment in the business—for the risk it takes—and not for the owner’s efforts.”
McCadden suggests net profit and owner compensation each should represent at least 10 percent of the sales volume for a company. Owner compensation contains not only salary but also bonuses and any other job benefits. For example, the owner of a company with a $1.5 million volume might make $110,000 in W-2 wages and another $40,000 to $50,000 in benefits, such as 401(k).
“The other way is you take your highest-paid person, whether it’s a salesperson or a production manager, and you better be making at least 20 percent more than they are,” Hanbury notes. “If you’re not, then you’re subject to an IRS audit. What sense does it make to work that hard with all that risk and not make at least 20 percent more than your highest paid person?”
Remodelers Advantage has its members integrate their draws and distributions, which belong on the company balance sheet, into their overhead expenses for monthly reports so the group can better measure business profitability. “They’ll have their salary on the P&L, but they won’t have their draws and dividends, so they get an inflated sense of net profit,” Downing says.
Remodeling companies must invest in infrastructure, such as computer systems and automobiles, to run their business. These expenses filter into overhead unless they contribute directly to labor on the jobsite; for example, the work truck a carpenter drives to the jobsite would be classified as a job cost, but the company car a marketing director drives to the office qualifies as overhead.
Even though the business might have already paid for these items, they will depreciate over time and require periodic maintenance until the company replaces them. Setting aside overhead dollars for upkeep and creating account funds for eventual replacements can help remodelers meet financial obligations in the future, and the larger overhead requires remodelers to increase their markup as the business grows.
“We actually started putting in overhead expenses for an entire office two years before we left the basement. By the time we left, we had over $125,000 in the bank, so we were able to buy a space, outfit it the way we wanted it and still have a few bucks left over,” Hanbury says. “And our pricing strategy had to go up before we actually made this big jump, so then we didn’t have to scramble to see if we could actually get that kind of markup when we were required to mark up that much.”
An overhead budget does not necessarily have to match the out-of-pocket expenses for a company in any given year but, more important, it should start to mimic what expenses might be in one or two years, Hanbury adds. Planning for the next phase of business long before the company expands equips remodelers with a superior ability to overcome challenges in a rapidly evolving industry.
“Most remodelers are artists, and it’s about the product and the beauty of the product, and not running a business,” says Les Cunningham, president and CEO of Business Networks, which places noncompeting remodeling business owners into groups so they can observe and assess each other’s companies, work together to generate solutions and learn from their successes.
“But after the job’s over, there’s nothing they can do, so they need to be job costing on a daily basis to track things,” he continues. “The biggest lie in remodeling is if you do good, quality work you’ll be successful at business; that’s absolutely not true. If you do good, quality work but you don’t charge enough, you will go bankrupt.”
Remodelers ought to think about the work they produce in dollars, or cost of goods sold, instead of how many jobs they sell, McCadden says. In doing so, they can readily mark up the costs for producing those jobs to cover both their overhead expenses and their target net profit; and as a result, they should know when they need to raise their prices because they are not selling enough dollars of work.
“I have no idea when I sold this if I’m going to make money, so if I try to produce this job as cheaply as possible—get it done as fast as I can and spend as little as I can on materials and subs—maybe I’ll make money,” McCadden says of the predicament many remodelers face.
“Once you understand the numbers, then you can understand what sort of changes to make and how it’s going to affect the bottom line,” says Downing, who advises remodelers to join a peer group for support. “We talk about it being a puzzle; all those financial puzzle pieces have to fit [together] in the right way. And when they do, the company really can make very strong profits.” | QR