When I first heard the expression “making the nut,” I wondered what it meant. Then, after watching a squirrel store nuts for winter consumption, I realized that this action depicted the operating costs also known as overhead.
One of the most confusing aspects of overhead is what it includes and when. Apart from labor units’ variations, this part of an estimate can determine how successful an estimate is. Overhead is a topic that requires a careful approach. Novice estimators often ask what a “good” figure is to use for overhead. The best answer is that it depends on the company’s operation and how their accounting system classifies the various costs.
Overhead stems from the gross profit a project produces. It means that all labor, materials, and direct job costs have been covered with funds to spare. We all hope the profit dollars will be sufficient to earn a return on the company’s cash investment in a project. Overhead basically includes those funds required to operate a business when no work is on the books. At this time the obvious telephone, truck, rent, license fees, and many other expenses come under the overhead umbrella. Every contractor incurs these costs.
Overhead and other fiscal matters relating to electrical contracting can be found in NECA’s “Financial Performance Report,” index number 1055, available through your chapter office.
The “Financial Performance Report” indicates that the average of those reporting report that materials and direct labor account for 62 percent of sales. The other 38 percent accounts for other costs associated with the sales, a third of which is attributed to overhead. Extrapolating figures this way is dangerous, because there is no basis for such costs.
The contracting firm’s size is inversely proportional to how much overhead financing is required. Smaller firms have a larger percentage of sales dollars attributed to overhead than larger firms. A sudden increase in the work in process will not generate more profits, because the unplanned, increased volume will require more overhead dollars.
At what point increased work can justify increased overhead is a sensitive decision that, if made arbitrarily, can cause a contractor to fail. An old expression that sums this up is “five or 15,” meaning that either five electricians work for a company or on a project, or 15. This number determines the required supervision. Some of this supervision may fall into the overhead column. Any number of supervisors between five and 15 is a dangerous financial area, because not enough overhead may be recovered if more supervision, or fewer installation hours, are required.
This is one reason it is imperative that estimators know the niche of work within which the contractor can produce the best profit margin. At the same time, the estimator must know the contractor’s capital capabilities so as to avoid work that requires large and potentially unavailable cash flows.
One statistic that skews any percentage or dollar value in a company’s financial reports is the consideration of the type of work the firm takes on. The larger the contractor payroll, the smaller the percentage of overhead when calculated against the company sales. The logical reason is that larger companies tend to take on projects of greater costs and they also produce more annual volume. Depending on the breakdown of materials versus volume, the higher labor project will require the greater overhead percentage.
At the same time, many operations or costs considered as overhead of a smaller firm or project often are included in the direct costs of a project, thereby excluding them from the overhead column. Some overhead costs will equal those partially covered under direct costs. For example, a telephone account that includes the home office as well as project telephone materials can lower overhead because considerably fewer company resources are used than are the employees that generate the project labor hours. These factors must also be considered in the overhead figure.
Other contractor operations recover all their overhead by a percentage applied to the labor price. These industries’ material prices are low compared to the labor rate, one being the sheet metal fabrication and installation part of climate conditioning firms. The overhead can also be recovered that way in the electrical industry, albeit that the resultant percentage will be much higher than the industry anticipates overhead should cost.
A firm’s overhead cost recovery is also linked directly to the contractor’s efficiency. It follows that, if a firm’s efficiency is high, the overhead costs will be lower for the same time period than the less efficient operation.
Enough overhead costs must be recovered for each job to cover its share of the overhead, or financial losses from other assets are inevitable. Overhead recovery is not a cookie-cutter percentage.
DAVID is a professor of electrical technology at Long Beach City College, Calif., a consultant, and an expert witness. He can be reached at (562) 597-1877 or via e-mail at email@example.com.