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Let's Talk About Overhead!

Overhead is often referred to as indirect cost, as opposed to direct cost. Direct costs include the wages-benefits you pay to your field workers and your cost for materials. They can be calculated rather precisely for each job.

Indirect costs include expenses for items such as tools, mechanical equipment, office supplies, trucks, fuel, advertising, liability and health insurance, utility bills, administrative salaries and various other things required to run a successful business, but for which it isn't practical to figure the amount used in conjunction with each job. Instead you must measure the total expense over the course of a year and apportion it to every job performed.

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Along the way you have to grasp the technique of providing for replacement of expendables trucks, tools, etc. that wear out or become lost. Who should pay for the truck or tools that wear out? You personally, or the customers you serve?

The answer obviously is the customers, all of them. You could not expect the last customer served to pay for a new truck if the old one fell apart at his door, so it's cost must be distributed among all the customers it serves during it's working lifetime. It naturally follows that all customers must be called upon to share in the replacement cost of other expendables you provide in order to maintain an efficiently operating business.

So, in a nutshell, overhead can be defined as all business expenses which cannot be accurately pegged to one particular job or charged to a specific customer. Yet your overhead still must be covered by the selling price you charge for each job, along with direct costs and profit. The question now becomes, how much will you have to charge so that each customer pays his fair share of your phone bill, advertising, trucking costs, insurance, etc.?

Numbers Crunching: The sad truth is, far too many contractors don't know the answer. They don't do the necessary numbers crunching to keep track of their business-related expenses. How often I have heard in my seminars and consulting work statements such as these:

      • I hate book work and don't have time for it.

 

      • Thats not my bag of tricks. I love to work with my hands in the field.

 

      • I operate from my home(or garage); therefore I don't have any overhead to speak of.

Sound familiar? Unfortunately, this attitude often leads to business disaster. It takes only a phone call to a supplier to find out the cost of a boiler, to the penny. But who do you call to verify your overhead cost of doing business? You have only yourself and your accountant to depend upon.

Another possibility may be your friendly competitors. Ask them what they charge for overhead and apply the same percentage to your own jobs. This is quite common and quite stupid!

First, your friendly competitor may be a good guy, but perhaps one of those blind leading the way people who don't understand the principles of simple markup. Second, your overhead expenses may be quite a bit more than his.

Overhead Accounting: Some contractors do keep track of business-related expenses, but fail to categorize them adequately. I've heard tales of Yellow Pages advertising, telephone and utility payments, gasoline receipts and a host of other expenditures dumped in a file labeled Bills! I suppose that if you we're diligent enough in compiling and adding up these costs, at the end of a year you could get a reasonably accurate sum total of your overhead expense.

What would be missing, however, is any understanding of your business and how to make it operate effectively. You wouldn't know what you we're spending too much money on and where you we're spending too little. You would lose track of certain expenses, and get into the habit of ignoring those little $5-$10 expenditures that add up to hundreds of dollars over the course of a year.

How one sets up accounts of overhead items is a matter of personal judgment. You can be very sophisticated or not so sophisticated. I recommend the former. The more detailed your breakdown of expenditures, the better you understand the business you're in.

What follows is a good sample format for classification of overhead expenses. It includes most of the categories relevant to a PHC contracting firm, although it certainly doesn't include every possible item. Depending on the nature of your business, you may want to add some categories, further subcategorize or eliminate some items that don't apply. As you scan the list, ask yourself whether you have any idea how much you are spending in each of the following areas.

Taking Pictures: Yes, dividing up your costs into so many different increments does demand a lot of the bookwork that many of you so much despise. But it is a task the must be done, whether by you yourself, your spouse or an office employee.

Whats more, you have to review your ongoing overhead expenses more than once a year if you are to employ expense accounting as a management tool. I draw your attention to the worksheet links on Annual Overhead Budget that appear below.

First of all, you should notice that the overhead items are broken down into fixed overhead and variable overhead. Fixed overhead refers to those costs that can be projected for the entire year with a high degree of accuracy. Variable overhead, as the term implies, is more likely to vary during the course of a fiscal year.

Now take a look at the two columns in the budget formats with reference to dollars and also percentages. The first two columns represent the anticipated annual expenditures in dollars for the various overhead items, and what those dollars represent in terms of percentage of anticipated annual gross sales.

The second columns represent the actual expenditure of each overhead account on a monthly basis. For example, I filled in the first line item, Proprietors Salary, showing an annual salary of $100,000. After the first month of the fiscal year the owner would have drawn $8,333.33 representing one-twelfth (8.3%) of the total budget expended to date. You want to make similar monthly entries for every line item on both the fixed and variable overhead sheets. (Of course, it helps a lot to have this accounting function computerized.)

This information is very important to you, especially the far-right entry which shows percent of budgeted dollars expended to date. If you discover, for example, that 50% of your budgeted dollars for a given item has been expended in the third month of the fiscal year, this sends an important message to you. You must implement measures to get back on track with this overspent item, perhaps by shifting money budgeted for some other item, or else by cutting back on spending for the overspent item the rest of the year.

This procedure is referred to as picture taking. You must take a snapshot frequently of the condition of your overhead, rather than once a year, as is the case with most PHC contractors. Knowing overhead cost at all times is as important as knowing what the material and labor direct cost of each job amounts to.

If you don't know what is going on with overhead expenses on a very current basis, you are betting on the come, which means you are playing a guessing game hoping that at the end of the year your total expenditures will balance with the amount budgeted.

My friends, if you decide that this monthly picture-taking is too much trouble, I recommend that you cash in your business assets and take you grub stake to Las Vegas or Atlantic City to play your guessing games there. Youre just as likely to go broke, but you'll have a lot more fun doing it!

Managing Overhead: A comprehensive overhead budget does more than merely inform you of where your money goes. It enables you to manage your company like a professional businessman. With a comprehensive overhead budget you can forecast annual gross sales, direct cost of sales, gross profit, and ultimately, net profit with a degree of accuracy unattainable with guessing games. It enables you to revise your business plan to meet unexpected conditions. It enables you to rein in a wild spending spree before it does fatal damage.

Without a comprehensive overhead budget, your business is like a ship leaving port for a destination without a navigator, charts or instruments. You are likely to get lost, flounder, run aground and sink.

Again, I believe this failure to understand and track overhead is the number two reason for rampant business unprofitability and failure in our industry. It goes hand-in-hand with the number one reason that so many PHC contractors flounder and sink failure to understand correct markup procedures and selling prices.

Before I call it quits this week, I want to draw your attention to some major overhead expenses commonly overlooked or misunderstood.

Rent: Earlier I referred to the misconception held by many contractors who operate out of a home or garage that they don't have any rental expenses. Even if the homes is paid up, a contractor who runs his business for person property is entitled to charge a certain amount each month for business rent. After all, the space he uses as an office or shop is denied him and his family for personal use. Moreover, the wear and tear on the property and furnishings is likely to be greater than it would be if used as living space.

The IRS issues guidelines for the proper amount of rent to charge, and I strongly recommend that you consult with your accountant and stay within those guidelines, or you may really get your you-know-what caught in a wringer. But don't give up what you can legitimately write off as an overhead expense.

Telephone: The same goes for telephone calls and utilities used in conducting your business from personal property. These items, telephone calls in particular, are definite business expenses, and you cannot afford to pay them out of you own pocket.

Depreciation: This is an item frequently misunderstood. As noted earlier, trucks and other major equipment and tools don't last forever. They eventually will have to be replaced, and they being to lose value from the moment you drive away from a dealers showroom or put them to use.

It can be determined exactly how much it costs to operate a truck for every hour it is owned and operated. This hourly cost is figured via depreciation, the amount the vehicle or other major equipment declines in value each year. Check with your accountant for the depreciation schedules that apply to relevant items, and be sure to include depreciation as an overhead expense.

Insurance: This is a very costly overhead item in this day and age. Sometimes insurance becomes a direct cost on a job, as some coverage such as workers and unemployment compensation are charged on the basis of so much per dollar of payroll. As long as the amount of labor is known, it is relatively easy to pinpoint this cost of insurance on any particular job.

Other insurance, however, is not linked to payroll and must be treated as indirect cost. These include fire, theft, auto and other coverage. Be sure to tally them as overhead expenses.

Salaries: The thing I want to draw attention to is what's sometimes referred to by the unfortunate term of nonproductive labor.

This does not mean that management and office employees do not perform useful functions, merely that their work cannot be measured in terms of a particular job like that of field labor. They must be charged to overhead.

Often a spouse or other family member serves as your bookkeeper or office manager. Keep this important concept in mind: If he or she is competent enough to perform the job for you, that person would have no problem maintaining the job in some other company. Thus, pay the person a competitive market salary, and charge it to overhead.

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Posted in Publishing and Printing Post Date 01/27/2016


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