Tag Archives: Overhead

Perspective on percentages

Estimating involves a lot of details and mathematics which must often be communicated with great speed and precision.  Unfortunately, there are terms that are so frequently misused that the information being shared is of little value.  A percentage is a simple concept with great utility and flexibility depending on your perspective.

Sometimes 10% to one party isn’t 10% to the other

Subcontractors regularly call to request bid results of the General Contractor (GC) estimator to define how closely their bids are following market prices.  Estimating often requires discretion during the bid (before the deadline) in order to maintain a fair competition for the subs, and to protect the firms interests.  All too often, the focus on discretion leads GC estimators to be incredibly reluctant to provide their bidding subs transparency in bid results.  The best bid results many GC estimators will offer is a percentage presented in vague terms.  “You were 10% higher than the low bid” is a typical example.

For simplicity’s sake, let’s assume that the inquiring subcontractors bid was $100,000.  Ten percent of $100,000 is $10,000.  So we might think the low bid amount was $90,000 so far, so good. But it’s wrong!

Perspective on percentages

“Yep, that’s the look of someone who’s made a rookie mistake.”

If the low bid actually was $90,000, adding 10% would make the 2nd low bidder $99,000 not $100,000 because 10% of $90,000 is $9,000.

In order to figure out the low bid amount, using only the information provided we can lay out what we know in an equation.

The percentage given represents the difference between the low bid, and the calling subs number in proportion to the low bid amount.

Putting this into an equation gives us:

($100,000-$Low bid)/($Low bid) = 10%

Solving for low bid we have:

($100,000)/( 10%+1) = $Low Bid

$100,000/1.1 = $90,909.09

Deducting the calling subs bid from the low bid give us the dollar amount they lost by.

$100,000 – $90,909.09 = $9,090.91

This means the calling subs was $9,090.91 higher than the low bid.

Rounding to an even $9,000, it’s plain to see that the calling sub would have needed to cut 9% from their $100,000 proposal to match the low bid amount.  Since the entire point of bid results is to define what you’d need to improve, it’s imperative to correctly interpret what you’re being told.  The GC’s is telling the sub they are 10% higher than the low bidder, when the Sub actually needed to cut 9% to match the low bid amount.

That simplified example might lead you to think 1% is no big deal, and on smaller projects, that might be true.  Have a look at what happens when we run through that example again with a 30% difference.

($100,000)/(30%+1) = $Low bid

($100,000)/(1.3) = $76,923.08

$100,000 – $76,923.08 = $23,076

Round that to $23,000 and the sub only needs to cut 23% from their bid to make up a 30% difference at the GC’s desk.  A 7% difference in perspective can lead to completely wrong conclusions.

Just to sum up, the GC is calculating the bid-result difference as follows:

($Sub bid – $Low bid) / ($Low bid)= % Higher than low bid

The sub is calculating the percent they must cut their amount to meet the low bid as follows:

($Sub bid) / (1+ % Higher than low bid) = % to match low bid

Many GC estimators prefer to give bid results in percentages because this minor obfuscation  spares them from actually speaking dollar amounts aloud where they might be overheard and misconstrued as bid shopping.  Bid shopping is when a GC informs a colluding subcontractor of their competitors price for the purpose of soliciting a lower bid.  In some cases bid shopping is illegal, and in all cases it’s unethical.

Subs calling for bid results should be prepared to think on their feet to rapidly calculate the hard numbers behind the percentages.  Responding to the percentage provided with “So the low bidder was $XYZ amount?” gives subs a chance to confirm what they’re being told, without obliging the GC estimator to speak the number aloud.

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Photo by Andrew Dobrow

Contractor cloaking technology isn’t very sophisticated

Subs should be especially conscientious about clarifying the bid results they receive from  Project Managers (PMs).  PM’s traditionally “buy out” the estimate which means they’re checking their estimators work, and addressing the problems they find.  They might have discovered that the  bid-day low sub was missing some costly scope inclusion, which made a different bidder the legitimate low-bid.  This vital error-checking process naturally requires  discretion to avoid the appearance of impropriety.  PM’s providing bid results after all that review may be looking at a considerably different situation than their estimator presented.  Honest PM’s will do their best to work out the errors in the order of bid-day performance.  If the corrective addition to the low bid makes the new total higher than the 2nd low bidder, the PM will hire the 2nd low bidder (provided their scope is complete).

I should mention that it’s a curious coincidence that many of the most dishonest PM’s I’ve encountered have a habit of saying every bid was “close” or “within 2%”.  Estimators should be particularly wary of clients showing any signs of dishonesty.  The false pretense of a  hotly contested bid is a potential warning sign of bid-shopping, especially when similar projects deliver a larger spread between bidders.

Where percentages work, and where they really don’t!

There are several components of an estimate that operate on percentages.  Profits, taxes, fees, and bonds are frequently calculated as percentages of the total costs.  There are some estimators who believe that overhead should be calculated as a percentage of project cost despite the many ways this goes wrong.  Unfortunately, this archaic thinking is sometimes bound into contractual terms where change orders are limited to predefined percentages for overhead and profit.

Overhead is the cost of doing business over time, which is not directly driven by the project cost.  Imagine a one month duration project that has a slightly cheaper level of finishes, resulting in a lower total project cost.  Did that decline in finish alter the rent at your office? No, your rent is the same regardless of what your client’s project costs, so why jeopardize the means to cover your overhead by pricing it as a percentage?   This practice virtually guarantees that projects above a certain value will be overpriced, while projects under that value will be under-priced.  In extreme cases, you’ll never win big jobs, and you’ll go broke doing little ones.

The difference between markup and margin

All business is a balance of risk versus reward; estimators calculate that potential reward in terms of profit.  It’s here that we encounter some terms that are often misunderstood, and misapplied.  Let’s say we’ve got a project worth $100,000 after all the costs are included.  Now for that $100,000 worth of work (risk), we’d like to see 25% profit (reward).  This percentage is known as markup.

$Subtotal X Markup % = $Profit

$100,000 X 25% =  $25,000

We add that profit to our subtotal and our bid amount is $125,000.

Now let’s say we won ten such jobs in one year.

10 x $125,000 = $1,250,000

That means the company had a total revenue of $1.25 Million.  So the boss is reviewing the books at the end of the year which will show all the costs, and all the earnings.  The difference between all the costs and all the earnings is your total profit.

We know that every estimate had $25,000 for profit, there were ten jobs, and to keep things simple, we say everything went perfectly according to plan on all of them.  This means the total profit should be $25,000 X 10 = $250,000.

Let’s take that $250,000 total profit and divide it by the $1,250,000 total revenue to determine the percentage of profit we’re actually earning.

($250,000) / ($1,250,000) = 20%

The percentage of profit we’re actually earning on our revenue is known as the Margin. As we can see, a 25% markup yielded a 20% margin.  This is where estimators need to consider what’s going on from an owner’s perspective.  The overall risk versus reward to the firm is the total revenue versus the total profit.  They’re not working off the subtotals of every estimate, they’re working off the contracted total amounts.  Margin makes sense when you’re working off of revenue amounts, because it directly speaks to the profitability of your entire operation.

Imagine how serious it would be for someone who misunderstood markup to be margin.  The 5% difference between 25% and 20% may not seem like much until you consider that profit to be their annual income.  That would be like working five days a week and only getting paid for four!  Many entrepreneurs  have failed because they didn’t understand this concept until it was too late.

Photo by strange_r

Photo by strange_r

Jim knew things weren’t adding up, but he couldn’t figure out why.

Just like the bid-results example above, the differences grow with the percentages in question.  A 25% Markup results in a 20% margin, whereas a 33% markup results in a 25% margin.  The percentage of markup is always higher than the margin percentage.

Putting this into formulas we get:

% Margin = (% Markup)/(1 + %Markup)

% Markup = (%Margin) / (1- %Margin)

We can calculate the total with a specific margin by using this formula:

$Total = ($Subtotal) / (1- %Margin)

So why do people get this wrong all the time?

The construction industry is very competitive which means that contractors must bid with lower profit percentages in order to win work.  It’s quite common for hard-bidding GC’s in tight markets to bid with less than 5% markup.  The difference between markup and margin is quite small when the percentages in question are in the single digits.  If the project isn’t worth very much to begin with, these differences become even less significant.  Sadly, many firms have leadership that developed bad habits when they were small and just starting out, that are ruinous to the larger operation they oversee in the present.

Fiddling with your fee

Sometimes markup is known as a fee which can get confusing when we are dealing with cost-plus contracts.  Cost plus contracts are invoiced on a “time and material” basis with either a fixed fee (set dollar amount), or a fixed percentage.

In the case of a percentage based fee, it’s absolutely critical to understand whether the fee is actually a markup, or a margin.  Contracts stipulating that the contractors fee may be no more than XYZ% of the total invoiced amount, are allowing the fee to be calculated as a margin.

Conversely, contracts stipulating that the contractors fee may be no more than XYZ% of the total time and material costs, are requiring the fee to be calculated as a markup.

This same logic applies to contractually stipulated overhead and profit percentages on change orders.  It’s been my experience that if the client took the trouble to stipulate overhead and profit percentages, they’ll likely limit those percentages to markup only.

I hope this article has helped to shed a little light on how percentages change with perspective.

 

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© Anton Takken 2016 all rights reserved

 

 


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.

Why overhead should not be figured as a percentage

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.

Why overhead should not be figured as a percentage

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