What Is The Right Approach To Applying Overhead Cost To A Project? | Operations from AllBusiness.com
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What Is The Right Approach To Applying Overhead Cost To A Project?

Too little cost in his bid and he pays to finish the job. The contractor might even be bankrupted on the way to complete the project. This may be "sudden death."

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The right application of costs makes contractor’s financial picture improve greatly. Not knowing costs has serious business consequences.

 

Too much costs in the bid and he won't win the project. He might not win any projects. This can be "slow death"

 

Too little cost in his bid and he pays to finish the job. The contractor might even be bankrupted on the way to complete the project. This may be "sudden death."

 

With an average net profit before tax of 2 to 5% for most construction contractors, the need for accuracy is high. Said another way, the difference between reward and punishment is slim.

 

Part of getting work is to know the final costs of the project. If we know our final cost, then the “poker game” starts. In a negotiation or bidding situation, good contractors play a great game if they are certain. Without certainty of our total costs, then we are in a weak position in this game of cards.

 

How do we arrive at an accurate cost? Two crucial steps among several are 1) The proper application of overhead costs for this project 2) Job sizing to proportion overhead and profit the volume of the job.

 

Some people advocate using a single rate derived from the contractor's financial information. Whether the job is large or small, heavy subcontractor/material or heavy labor/ equipment, it makes no difference. The school of thought is that the single rate will cover all scenarios.

 

We strongly believe using a single rate application for all costs on a job works for a contractor doing identical projects week in and week out. They are the same "slice of bread" - white not pumpernickel. That is, if all the projects have consistency in the amount of labor, material, subcontracts, equipment and other direct costs to each job then the contractor can use a single rate with confidence. However, very few contractors have a repetitive project type.

 

But the construction world is dynamic, never the same and will continue to experience new demands in regulations, labor management, technology etc. This is especially true in the areas of commercial, multi-residential, custom home, industrial, highway and the like, where completely different job requirements in each letting.

 

If we use a single rate and look at two projects with a different labor to material/subcontract ratio. We see the fault immediately. More labor is more expensive to manage. It takes more home office salaries (President, Safety Director, Payroll Manager etc), more equipment (computers, office space and trucks for those salaries) and other headquarter expenses.

 

This may be why the use of subcontracting has risen over the past years.

 

On a project basis, the high labor % job one where we know there is a lot of home office support needed. Meaning overhead costs are high but we are costing it at a single average of total office overhead to labor/material/subcontracts direct costs.

 

When bid this high labor content project, we will apply less cost. This will make us low bidder. We will win this job but, it will be more costly to build. Most of our competitors will add cost and have higher bids.

 

On the other extreme, the low labor content project will show the other failing of using a single rate. We will use the same average overhead percentage, however this project will be simpler (less costly) for the home office to support. Our average cost application will be disproportionately higher. Therefore will not be competitively priced and it will not draw attention (or an interested phone call) from the client.

 

Using a dual rate is more realistic application to the nature and behavior of construction costs. To illustrate, when we cost overhead to a job, we will use a different rate of overhead to add to labor than to material. Again, labor is always more expensive to manage. I sometimes ask this question to clarify to others, "which would you like to manage? $1 million dollars of subcontractors or a $1 million of labor on a project?". All construction professionals would much rather manage the subcontractors. It is a much easier and less time consuming challenge than leading dozens of journeymen, apprentices, laborers and their equipment to build work efficiently, safely, and with quality. This translates into less cost for the company.

 

The dual rate model is derived from banking information. That is, the financial relationships experienced by real world contractors. Not a theory represented as a practical solution.

 

Our firm performs this kind of work with construction contractors nationally. We assist firms in applying this methodology to their business. This area makes for a long discussion contained in another article.

 

As a conclusion, this is one of the business processes (of several) which drive the contractor’s business to an appropriate place on the construction’s risk / reward curve (see risk / reward curve article). With it, the contracting business will produce a better financial reward and in addition, should be less stressful.

 

For more information on this critical subject, purchase a copy of my McGraw-Hill book, Managing a Construction Firm on Just 24 Hours a Day. We offer a bundle with Excel templates that are featured in the book and 5 on-line courses to help teach construction business concepts. Go to www.stevensci.com and click on the book link

 

Our workbook companion with 10 case studies is titled, The Business Managment Workbook for Construction with Case Studies is now available.This text is focused as an assist for Colleges, Associations and Contractor Training Programs that teach the business of construction.

 

My next book, The New Business Model of Construction Contracting is planned for December 2007. Its focus concerns the changing construction environment and what processes address those changes.

 

Matt Stevens is President of Stevens Construction Institute, Inc. A management consulting firm which works only with construction contractors. Learn more at www.stevensci.com

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