McCadden: What to Know About Overhead and Profit

by Kacey Larsen
overhead

Unfortunately, most remodeling business owners don’t have an accountant; they have what I refer to as a historian. As a result, at tax time, their historian certainly tells them what happened—when it’s too late to do anything about the results. Instead, the right accountant will also help you plan ahead for profits and strategically organize how your chart of accounts appears on your profit and loss report. This is important because how a remodeling business should separate direct costs from overhead is different from how the same information has to be reported on IRS tax forms. I’m betting at least one of two things is happening here—maybe both. Either your accountant never shared that clarification with you, and so doing your taxes is easy for him/her.  Or your accountant has no idea how a remodeler’s chart of accounts needs to be organized so the business can properly determine and measure its required gross profit margin. Here are a few things to consider and perhaps share with your accountant.

Don’t Blame Your Accountant

If you have a historian, I ask you to step back and ask yourself why. Remember, you first hired that person, and it’s up to you to replace that person if you are not getting what you and your business need. As a business owner, what good is it if your business does bookkeeping that solely serves your accountant’s purposes and, as a result, leaves you blind when it comes to measuring your business’ profitability? Is it because you don’t understand accounting? Is it because the information I am sharing here is new to you? Regardless of why, either speak to your accountant about the help you need or, if you have the wrong accountant, seek referrals for a new one. Interestingly, about eight in 10 of my coaching clients fire their current accountant and get a new one once they begin working with me.

Direct Costs vs. Overhead and Profit

Your business needs a strategy to separate job costs, otherwise known as direct costs, from business overhead, also known as expenses. It is important to recognize that how costs and expenses are separated in your bookkeeping should also be applied the same way when you estimate and price the projects you sell. You must be able to estimate your direct costs separately first, then apply a markup adequate to cover your overhead as well as your profit requirements to determine a profitable selling price for each job you sell. Then when you sell the job, you can enter this separated information into your bookkeeping software—QuickBooks for example—as the project budget. To ensure apples-to-apples job-cost comparison reports, you must also properly separate and enter actual costs and expenses into QuickBooks as you do business. Done this way, you can price and sell jobs at a predicted gross profit margin and use your financial reports with the confidence you are comparing apples to apples, not apples to bananas! Did your accountant discuss and help you with this? If not: historian.   

Covering Overhead Is Not Magic; It’s Simple Math

The markup your business uses should add to your estimated costs the money needed to properly price jobs so each one contributes its share of gross profit to the overall annual total needed. To determine the markup needed to cover your annual overhead and profit, first add them together and then divide that sum by the dollars of direct costs you expect to sell during the same time period. The resulting number is your markup percentage. For example, a business predicting $400,000 of overhead and profit and $600,000 of direct costs would need to use a 67 percent markup ($400K/$600K= .66666, or .67 when rounded up). To simplify the math, put a one in front of your markup and you will get right to your sell price. To prove the math: $600,000 of direct costs marked up by 1.67 equals a sell price of just over $1 million (due to the rounding). As long as direct costs were estimated accurately at $600,000, this business will have $400,000 to pay its overhead and profit.

It is also important to recognize the markup has been calculated based on selling that $600,000 of direct costs. If you plan to sell $600,000 of costs, but end up only selling and producing $500,000 of costs, you will come up short on the gross profit dollars you actually need. That’s because the $100,000 of costs you didn’t sell didn’t get marked up by that 1.67 markup ($100K X 1.67 = $167K). The result will be having $67,000 fewer gross profit dollars to cover your $400,000 overhead and profit. Did your accountant discuss and help you with this? If not: historian.

This may sound a bit harsh, but this is simple grade-school math. There should be no excuse for running a business without knowing which markup to use and how to determine it. The key is to have someone you trust who is qualified to properly explain and help you apply the math and accounting strategy needed to price your jobs for profit, so you can see how much money you are making as you do business—not just once a year after the fact. |QR

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