Why overhead should not be figured as a percentage

Don’t get trapped

There are quite a few traps that people fall into when it comes to overhead and profit.  Perhaps it comes from a desire to simplify operations or a lack of follow through but one thing is certain: percentage based overhead calculations aren’t accurate most of the time.  It’s possible that a given percentage on a given project will end up covering the overhead costs for that project’s duration.  It’s just unlikely.

Overhead is not optional, imaginary, or driven by profit

Lets start with the nuts and bolts of overhead.  These are the costs of doing business.  Everything from office rent to printer paper get’s paid out of overhead.  Depending on how a company is structured, overhead may also pay the wages of staff members.  With rare exceptions, overhead costs are predictable and occur at regular intervals.

Like ammunition for example…

The key element I’d like to call attention to is that overhead must be paid as a function of time.  Rent will come due every month – it has nothing to do with how well the jobs are going.  As a bare-bones issue, overhead is a non-negotiable sum you must be earning at all times or you’re losing money.  Even non-profit companies MUST make overhead or they’ll go under.

Getting a handle on it

Figuring out overhead isn’t complicated, nor does it need to be.  I recommend taking the entire years worth of overhead costs (or projections) because some items are only payable annually.  For example a subscription to a trade publication, or the renewal fee for a license.  For companies with several years of records, I would encourage you to calculate the years separately to see year to year differences.  We’re looking to establish a baseline, not split hairs.

So annual costs (or projections) in hand it’s time to add for inflation and growth.  For the sake of simplicity let’s say that in an improving and expanding market, a 5% add is in order.  For a depressed market, it could be lower.  Unless you’ve got great reason to do so, don’t go negative.  Take this annual figure and divide by twelve for monthly overhead. Divide the total overhead by 52 for weekly.  Take your weekly and divide by five for working days.

Notice how I didn’t take the annual and divide by 365 to get days?  Working weekends isn’t typical for most businesses.  There are 260 working days (no holidays) in a year.  One way to handle the holidays is to assume 50 working weeks per year which give 252 working days per year.  The goal is to shift the overhead costs onto the working days.

Each job pays its own way

Now that we’ve got the daily overhead rate we need to answer some job specific questions.  First off, how many jobs will be going at the same time?  Each job needs to carry its fair share of the load.  Looking at company history to see what the average concurrent job count is will prove helpful here.  If there’s reason to believe you’ll have four projects going at all times, the overhead rate applied to each job should be a quarter of the total.  I call this office commitment. Be warned that each job is different.  If you’re looking at a very large job, it could consume all the companies resources for its duration.  Similarly, a “hurry up” job that requires you to drop everything would affect its bearing on your overhead.  You will quickly see that faster is cheaper.  A notoriously disorganized client, architect, or owner should indicate that a higher portion of your overhead costs will be attributed here.

Pictured above: A typical Owner, Architect, Contractor meeting.

Delayed gratification (and payment)

So are we done?  In a word, no.  The sad fact of the matter is that work is nearly never paid for as quickly as it’s done.  A standard practice in the construction industry is to withhold payment equaling 10% of contract value until the project is complete. A heavy equipment contractor would obviously complete their work well before a building is completed.  That contractor may not see full payment for several months!  Any financing costs arising out of their need to cover bills while awaiting final payment must be paid out of overhead which can be factored by the actual delay in getting paid.  Running a quick scenario, imagine it takes two weeks for that heavy equipment contractor to do a job and there’s about $1,000 a week in overhead for the operation.  If it takes sixteen weeks to get the last 10%  then $200 worth of the overhead is accruing interest for four months.  Let’s say it’s a credit card interest level of 15% which makes the additional cost $30 for the first month, $34.50 for the second month, $39.75 for the third month, and $45.64 for the last month.  Because it’s compounding, that delay ended up costing $149.89 to the contractor even if they got on to other projects while awaiting payment.

Taking stock of all these factors, you will arrive at a total overhead cost.  The overhead is not driven by how many people are working on site because those folks are job-billable.  The overhead is not driven by project cost because again, all of that is job billable.  Project duration, inflation, payout delay and office commitment are the only factors driving overhead.

Unintended consequences

Getting back to the headline of this article, I’d like to illustrate why percentile overhead calculations are so ruinous.  First off they work on the assumption that all jobs will consume overhead proportional to project cost.  This has the effect of charging too much overhead for jobs you’re really efficient at, and charging too little overhead for jobs you’re not as efficient at.  By extension this causes bids to run higher on jobs that more perfectly align with the companies abilities.  Conversely this causes bids to run lower on jobs that don’t align as well.

Let’s say we’re a company that furnishes and installs millwork.  There are two jobs to install millwork in commercial spaces.  One job specifies more expensive laminate material than the other but every other factor is the same.  Does it make sense therefore to bid a higher overhead amount for the nicer laminate?  Jobs are often won and lost by such amounts.  A set overhead percentage will only fit one dollar value perfectly.  Everything else is a bet against the future that you’ll pay for in lost overhead, or lost jobs.

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© Anton Takken 2014 all rights reserved