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Every shop must determine a labor rate, and that rate needs to be
determined by both historical and current data. The original question
concerned how to determine overhead for each employee. That is just as
important as managing sales. If you don't know what your overhead is, what
do you base sales on?”

I answered the original question by saying that I don™t think that overhead
should be based on employees, per employee, or per man-hour. I know
what my overhead is, and based on historical data, obtained from a simple
profit and loss statement, I can apply that overhead percentage of past
sales to future sales (estimates and proposals) with confidence that if I sell
the same amount next year, I can expect at the very least, the same results
this year, and if I sell more, the additional overhead converts to additional
profit - my reward for being diligent, knowing my costs, and managing my
sales level (I have not been charmed into managing my sales level, I have
just been rewarded financially for doing so, and will choose to continue
doing so). Anytime I can focus on one item instead of three (I did not say
ignore the other two), I feel my chances of success are better.

You stated: “Most estimating is done by determining labor costs and
material costs, then adding the appropriate margins (overhead and profits).
If you waited to see what sales would be in the month that job is produced,
you would never be able to price a job.”

As I have already stated, the overhead PERCENTAGE is based on
historical data (last year™s overhead as a percentage of sales). Once the
percentage is determined, it is simply applied to each estimate or proposal
as a percentage of the sale, just like net profit. Once you have determined
your material and labor cost, you add all the appropriate markups (all
percentages) for sales commission, design fee, engineering fee, overhead
and profit. This makes two identical jobs cost the same thing every month,
regardless of sales level. If the method you are using produces the same
price on two identical jobs, then we are arguing about details that are
meaningless. If the method you are using produces different prices for two
identical jobs, then you are in a very different place, and you must
understand that when sales decrease, your prices increase, which could
possibly produce even less sales.




6 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...



From contributor B:
Contributor U, I think we're saying the same thing, we're just getting there in
a little different way. To me, the most important idea you're presenting is
that your markup should be based on the slowest month in sales (or the
dips). In our business, our jobs overlap and it is impossible to know a
monthly sales volume until you're right on top of it. We have certain jobs that
bid a year before we produce them and others that are fast track. They all
overlap.

I can't agree with you more that sales are crucial in making sure you meet
overhead. In my opinion, sales (or lack of) are often what kills people in our
business. More importantly, they fall into the cycle of realizing they have no
sales, then undersell work to meet overhead. They fall behind, then never
recover.

I also completely agree that overhead must be spread between BOTH labor
and materials. Whatever formula is correct is debatable. More important is
that you use a formula (and I think a great number of smaller shops are just
guessing).


From contributor D:
Contributor U, after reading your posts, I wanted to clarify something. As
you know, I believe in recovering my overhead through labor, or through the
amount of time a project spends in the shop. I do not recover overhead
through materials because of the unusual price fluctuations this can cause
that customers don't understand, an issue that we already covered on your
forum.

You seem to think that if I have a slow sales month, I am somehow less
able to recover my total overhead expenses using factors than you are
using percentages.

Your percentage is based on an annual overhead amount averaged over 12
months. You rely on good months to balance slow months. My factors are
also based on annual overhead averaged over 12 months, and I also rely
on good months to balance slow months. The overhead rate that I attach to
every man hour worked is loaded to account for those slow months, just as
your percentage is loaded.

You maintain that if I have a slow month and am not able to recover my
overhead through man hours, I will not have the opportunity to catch up.
This is no truer than if you had a slow month. If you or I had no sales for a
year, neither of us would be able to cover our overhead.


From contributor L:
In reply to contributor B™s questions... For me, overhead is always a fixed
amount. I recalculate my overhead 3 to 4 times a year to keep on top of any
changes. It is absolutely not covered on bad months. Nobody's overhead is
covered on bad months. In fact, I think that is the definition of a "bad"
month. Overhead is recovered in the good months, but the "good months"
translate into higher volume months.

That is why I believe that machinery is a better utilization of overhead
dollars than employees are. Machinery responds to an increased workload
much more efficiently than employees do.

I apply overhead to a job based on the total time estimated for the project.
That includes the layouts, machining, material handling, cleanup, site
involvement (multi-level houses, number of miter joints, pita contractor,
finished floor, cut in boxes, toe kick heat registers, etc). The total time is
something that only experience can teach you.

My formula for estimating is (MATERIALS) + (SHOP RATE) X (TOTAL



7 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


TIMES FOR ALL SERVICE ITEMS) + (OVERHEAD RATE) X (TOTAL JOB
TIME) = JOB COST OF PRODUCTION. JOB COST OF PRODUCTION +
THE DESIRED MARKUP AMOUNT (true profit) = JOB ESTIMATE.

By keeping the desired markup high enough to cover the bad months, each
individual customer is amortizing a completely fair and just amount of the
shop overhead as they should be. After all, I don't have all this machinery to
manufacture products for myself. Whenever someone comes into the shop
and says, "You sure have all the toys" I look them right in the eye and say
"THESE ARE NOT TOYS!" (translation “ “You are paying for them”).


I use a burdened labor to account for overhead cost also. I can see
contributor U's point, but we (10 man custom res.) do raise our price to
compensate for slow sales. I have found that lowering my price to increase
sales when we are slow only ties us up with less profitable work and has
cost us some opportunities for work that would have moved us forward
financially. Part of managing sales, to my thinking, is pursuing the projects
which most fit your circumstances. This strategy, of course, only applies to
our business, which is custom residential and mostly remodel and in which
we control the point of sale (no contractors, designers, etc.) I apologize for
getting to far off topic but conversations about overhead factoring must
eventually address sales and marketing.


From contributor A:
I am assuming, based on the content only, that most of you guys have fairly
decent size shops. I guess it only reassures me to stick to the 3-4 man shop
size. My fixed overhead changes minimally each year. It is changed by
interest rates more than anything else. I cover my overhead in my charge
rate. So if my guys work their 40 hours and meet their productivity rate, I'm
beating my budgeted margins.

I guess what I find interesting is that many participating in this discussion
must work on very tight margins - that is, if overhead plays that big of a role
to be profitable. Don't get me wrong. I'm not minimizing the importance of
overhead, but it is a minor figure in my business compared to things like
labor and materials.

When I review my pricing structure each year I tend to look more at my
productivity rate, cost of materials and cost of labor. I think that materials
drive my price increases more than anything else, and even then I often am
able to recapture that throughout the year by negotiation.


From contributor B:
In our 25 man shop, overhead is a huge part of our business. I'm not sure
where we stand in comparison to other shops, and would like to know. But,
even if I knew, it would not matter. We have to recoup those costs in what
we charge.

In our business (custom architectural woodwork), the estimator plays a
huge role in rather we make money or not. Since each of our projects is
different, it is impossible to have good time studies.

Some things are always different on a job (material, details, finish,
customer, etc.) and it is really an educated guess as to how much labor it
will take to complete a job.

It is my feeling that this guesstimation is where most of our competition fails.
We see so many shops go in and out of business - it's just crazy. Our
competition seems to be from two schools:

1- Previous unrelated business owner who knows nothing about custom
woodworking and thinks buying a bunch of equipment is the right answer.
They then bid work not knowing that there's a great deal of the custom side



8 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...


of work that simply can't be done with equipment (or if so, the equipment
can't be justified).

2- The passionate cabinetmaker who loves what they do, and thinks they'll
make a go of it on their own (hey, the boss plays golf once a week and must
be making a ton of money - it can't be that hard). They don't understand the
money side of it and underbid work. They usually base their bids on "I could
have done it that fast", not realizing their employees won't be as motivated
to work as hard as he might have been.

I'm just trying to be a little of both (only the best of each).


From contributor U:
Contributor A, my company consists of two full time employees and myself.
My typical net profit is between 28% and 32%

Contributor B, my typical overhead runs between 15% and 18%.


I use an Excel spreadsheet to forecast what the income-expense scenario
needs to be to make it pay when I want to add an employee.

It helps to have a few years going back of accurate year-end accounting
information.

I set up a labor spread showing each employee, existing and proposed, the
hourly rate they make x regular hours, plus overtime hours (on an average
basis), etc.

I plug those totals over to an income-expense spread that basically
resembles a standard monthly income statement showing sales, costs of
production, and general expenses. The scenario works off of yearly income
and expenses, so you are not concerned with monthly trends that are not
predictable.

Most expenses are either fixed, or they change on a percentage basis. For
instance, payroll taxes are a fixed percent of labor cost. Some costs
increase as production increases. If material costs are not predictable on a
*yearly* basis, run your scenario without these costs, since you are going to
charge appropriately on a job by job basis.

Essentially, I have a spread where I can plug in any number of new
employees, plug in wage-hours or salary, etc. The spread calculates
automatically what this does to the bottom line. Then I adjust the income
goal to the amount necessary to achieve desired profit. Set a weekly
production goal average and keep your eye on it. Oh, and before you hire,
don't forget to ask yourself if you are sure you can sell this much business
consistently to meet the goal.

This has been a great tool for me. In earlier years, I would add employees
as backlog increased, not knowing what my production needed to be. This
is a recipe for an illusion of success that really only amounts to you working
harder while losing your butt.


The comments below were added after this Forum discussion was archived
as a Knowledge Base article (add your comment).

Comment from contributor C:
I think there is a lot of confusion on costing. The first step is to get with your
bookkeeper or accountant and truly understand your fixed and variable cost
structures. Also, understand capital expenditures (amortization) versus
expensed items. Much of what is discussed is relative to basic accounting
principles.




9 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...



The other critical point to understand is historical costing and actual costing.
In a job shop environment you should be looking at actual costing methods
always. One contributor mentioned he used a spreadsheet - yes, this is a
great tool. Develop your formula for fixed overhead, labor rates inclusive of
variable overhead for different aspects of a given project, your material
markup and most important use waste factors and variance factors. Apply
those to both time and materials. Cost your project using the time and
material rates as close as possible to the actual estimated process. Then
add your fixed overhead rate plus profit. This will give you a good estimate.
Now measure your project as it is completed against your estimate. Most
importantly, do your historical analysis and adjust your factors accordingly.
Over time you will develop a very accurate costing model for your business
and review it with your accountant or bookkeeper whenever possible.
Estimating is a science and an art. I always recommend a good accountant
audit or review of my methodology. If sound, it will be a solid framework for
your business.

This whole discussion starts with adding an employee(s) - labor is a variable
and equates to hours expended. Labor is typically not a fixed cost - though
if you have order entry people or customer service it can be part of your
G&A cost structure and then is a fixed indirect cost. Understand the
differnce between indirect and direct labor - this will help you develop a
better understanding of costing principles. Develop percentages for
employee benefits - add this to your base variable labor cost. This will then
get applied equitably via billed hours. Don't markup labor - use variance
factors as your tool. Variances are historical data - the more detail you track
per project the more accuracy you'll bring to your costing model. Have the
discipline to run labor and material sheets in your shop on all projects.
Collect and input daily - track every aspect possible on a project.

Aways remember you should be able to explain your methodology to your
customer and it should seem fair - you do need to compete in the market.


Comment from contributor P:
For our company, overhead per employee or employee hour is something I
have never considered. It may be helpful to understand this ratio in
considering the overall health of our company, but I don't think we would
ever consider it in determining the rates we charge or estimate, which are
always determined by what the market will bear.

We view our overhead from a different perspective: 1. What is the
appropriate overhead expense as a percentage of our annual gross receipts
with static growth? 2. By what amount or percentage can our overhead
exceed that generically-imposed appropriate percentage as an investment
in growth? In short, how much can we afford to invest in the buildup of our
company, with its roots in increased sales, and development of our ability to
perform the associated increased work?

This can be a very difficult issue to grasp and manage and I have been very
focused on it recently. When I brought these issues up to our internal
financial people and our accountant, I was amazed at how unprepared they
all were. They were unprepared because all of their discussions were about
payroll, workers comp, taxes and credit - the urgent stuff.

It is clear from speaking with my staff and reading these articles that
everyone has a different concept of what constitutes overhead and what
percentage of annual gross receipts overhead should be.

I have asked our controller for an analysis of our overhead defined as all
expenses other than direct site expense or cost of goods sold.

Workers compensation is not overhead, except as it applies to office staff,
because it is a component of payroll tax on labor, which is a direct site
expense.




10 of 11 4/2/2005 1:37 PM
Overhead per employee http://www.woodweb.com/knowledge_base/Overhead_per_employee...



Liability insurance is a variable cost under overhead, since it increases as a
dollar amount with sales, though it shouldn't change much as a percentage.

This discussion and these definitions are as important to me as cost
accounting and, in fact, I consider them together: How much do we make on
our jobs, how much must we retain to keep it safe, and how much must we
invest in staff, software, training and estimators to allow me to go out and
sell.

To know fixed overhead is one thing, but to manage discretionary variables
within overhead is what it is all about, because sales and profits vary and
we must tool up and down in the office as well as in the shop and field while
continuing to realize growth overall.

I need to know at all times what amount of our overhead is overhead and
what is capitalization of growth, and I wish someone would tell me what
percentage of gross receipts overhead should be, but I would never base
my prices on it.

We all know twenty contractors who charge 10% profit and 10% overhead,
but do we know any whose overhead is actually 10%? No, we don't.

Have you reviewed the related Knowledge Base areas below?
KnowledgeBase: Business
KnowledgeBase: Business: Estimating/Accounting/Profitability
KnowledgeBase: Business: Project Management
KnowledgeBase: Business: Sales




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