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Last month’s column described the use of the Eichleay formula for recovering overhead costs in change orders. The rationale for using this formula is that the overhead required to compensate for a time extension or increased crew size caused by a change order must produce sufficient financial resources to cover the resultant home office expenses. Home-office expenses are certainly part of the company’s overhead. Whether it be a change order or normal business operation, overhead costs must be recovered or any expected net profit will be affected.
The method used in the Eichleay formula is centered on the number of days required for a change order in the overall picture of a company’s overhead. This approach can also be used for relatively normal overhead considerations.
Using NECA’s Financial Performance Report, for companies in the $5 to $10 million range of annual revenue, the major allocations indicate direct project costs are close to 80 percent and represent the major component of the income statement. Twenty percent remains for the overhead and operating profit.
A pie, which represents 100 percent of the revenue from a project, can be cut into three slices: 31 percent for materials; 41 percent for labor costs; and 28 percent for other direct job expenses and subcontractor costs. Extrapolating these figures shows that 40 percent of the project is material costs while 60 percent is the labor-factor costs. Coincidentally, these percentages have been reasonably stable for any number of years for the average electrical project.
When projects deviate from the norm, varying approaches must be considered. Without adjusting the overhead, some projects may not be self-sustaining and will actually end up affecting the company’s bottom line. Typical projects can be either material-heavy, such as sports-field lighting, or abnormally labor-intensive. If the overhead is based on a standard percentage, it becomes apparent that inordinate amounts would be recovered toward meeting the company’s financial well-being.
The sheet-metal industry is one where the value of the materials does not increase until the required item has been produced. If that industry were to use overhead recovery, as is done on many electrical projects, the companies could not thrive. The sheet-metal industry is one that uses the labor-burden approach to recover overhead.
Typical electrical projects that should use the labor-burden approach are certainly those where the materials provided by the contractors are a very small part of overall project costs. These types of projects lend themselves well to the Eichleay methodology.
The beauty of the Eichleay formula is that it is based on the number of hours worked. Other considerations, such as hours required for project supervision, are similarly based on hours.
There’s no doubt that high-priced materials do involve overhead costs. Considering $100 as direct costs and assuming that $80,000 represents the material costs and $20,000 the labor costs, this project could generate $15,000 if a 15-percent figure is used. No one will argue that this would be a very pleasant prospect, but not a reality in the competitive world.
This project bid must be scaled back to win the job. Assuming a 5 percent markup is applied to materials, allocate $5,000 toward overhead. If the company’s overhead were 16 percent as it relates to sales, to produce an equal amount if the overhead were based on labor, the overhead percentage applied to labor would have to be only 64 percent.
Using this approach, the project would generate $5,000 based on materials costs. To recover the overhead costs for the 20 percent of the project’s labor portion, some $3,200 has to be generated. The total overhead recovered then amounts to an 8.2 percent addition to overhead, probably a more realistic and competitive figure than the 15 percent addition.
NECA’s Financial Performance Report (Index number 1055 and available through your chapter) can be the basis of a variation of considerations. The report contains tables that apply percentages using sales as the 100 percent base, as well as several other tables based on direct costs, direct labor and company assets. There is more useful information to be gleaned from the report for assessing a company’s health.
A word of caution: These figures are representative of the industry and should not be treated as gospel. But they will provide a foundation for further discussion or research with the company’s financial gurus. EC
DAVID is a professor of electrical technology at Long Beach (Calif.) City College, a consultant and an expert witness. He can be reached at 562.597.1877 or at [email protected].