CONTRACTOR SECTION
Applying Overhead
and Determining
Break-Even Cost
The fifth installment
in a multipart series,
this article examines
how to determine
the break-even cost
for a project.
N
By Mike Holt, Mike Holt Enterprises, Inc.
ow that we’ve discussed the list of expenses you must include in any
estimate, it’s time to add them all up. Before we do, though, we
need to determine what it will take to break even. The break-even
cost for a project is equal to the prime cost plus overhead cost.
Find the prime cost by adding up the cost of labor, material, and direct
job expenses. The following table demonstrates the calculation of estimated prime cost based on previous articles in this magazine.
Continued on page 44
Figure 1
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July 2001 • EC&M • www.ecmweb.com
CONTRACTOR SECTION
Continued from page 40
Where finding the prime cost is a relatively basic
operation, overhead can present some complex challenges—particularly in its applications. If applying
overhead to the job isn’t the most difficult step in the
estimating process, it’s at least one of the most intimidating. This is because most people in the construction
trade do not understand what overhead is and how it
is calculated. Overhead is the administrative costs
required to manage field labor. These administrative
costs include administrative staff salary, taxes, benefits, rent, phone, and office expenses.
There is a right way and a wrong way to apply
overhead expenses to an estimate. You can use
either the percentage method or the cost-perhour method.
Although it’s the most popular method, using percentages to find overhead can get you into trouble.
Most contractors apply overhead to a job as a percentage of prime cost, and in many cases they don’t base the
percentage on anything. Sometimes a contractor will
incorrectly derive the percentage from the income
statement supplied by the accountant:
Danger: Typically the percent ratios listed on the
income statement are given as a relationship to sales.
Do not use this value!
Let’s say your prime cost is $7000, and according to
your income statement, your overhead as a percentage
of sales is 25% and profit is 5% of sales. Many electrical
contractors make the mistake of using 25% (percentage of sales) for the multiplier for overhead and 5% for
profit.
This method is
wrong because the
25% listed for overhead and the 5% for
profit on the income
statement are based
on a percentage of
sales, not a percentage of prime cost. Because you don’t know what the
job is going to sell for, you can’t use the percentage of
sales; you must use the percentage based on prime cost.
If you use the wrong percentage, you could end up
bidding the job at $9188 instead of $10,010. You
might get the job because your bid was $332 below
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July 2001 • EC&M • www.ecmweb.com
your break-even. The table above demonstrates how
to correctly determine overhead.
If you have been in business for awhile and it seems
like you’re not making much money on the jobs you
complete, then this is one area you need to discuss with
an accountant. It’s possible you’re not using the correct
percentage for overhead and profit.
Properly applying overhead. Labor burden (payroll
taxes, insurance, and other labor-related costs such as
vacation pay, holiday pay, sick pay, pension, etc.) must
be included in the estimate, but you don’t want to
include it twice! Most electrical contractors do not
separate labor burden cost from overhead in the income statement. If you are one of those contractors,
then you must not apply a labor burden percent to
labor when you figure your labor cost, because this cost
will be included in the estimate when overhead is
applied. If your accountant has separated labor burden
from overhead cost, then you’ll know what percentage
to apply to burden. Then you can simply apply overhead without being concerned.
Overhead per man-hour. Because overhead is an
administrative cost necessary to manage field labor,
overhead should be calculated using the cost per manhour method. The advantage of the cost per man-hour
method is that it allows you to recover overhead
expenses quickly, easily, and accurately. Calculate the
overhead cost per man-hour by dividing the overhead
dollars (as listed in the income statement) for the past
six months by the number of field man-hours for the
same period. The following table demonstrates this
calculation using the formula:
Overhead cost per hour = overhead cost ÷
field hours
CONTRACTOR SECTION
Other factors to consider. When applying overhead, you should consider how your business volume,
job size, and contractor size impact the rate you would
use for the estimate.
Business volume. Most overhead expenses do not
vary much with changing business volume. However,
as business volume (labor hours) decreases, the overhead cost per man-hour increases. As business volume
increases, the overhead cost per man-hour decreases.
Using the overhead rate of $10 per hour and
assuming the business volume decreases 20%, overhead can only be reduced by 10%. The new overhead
rate per man-hour will be $11.25.
Now, using the overhead rate, let’s assume the
business volume increases 20%, and overhead only
increases by 10%. Instead of $10, the new overhead
rate per man-hour will be $9.16. (See the example at
the top of the page.)
Job size. Smaller jobs require a greater proportion of
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July 2001 • EC&M • www.ecmweb.com
administrative cost relative to labor costs, as compared
to larger jobs. Therefore, when you bid jobs that are
larger than your average job, you might want to consider using an overhead rate that is less than the
calculated overhead rate per man-hour. For smaller
jobs, you might want to consider raising the overhead
rate per man-hour.
For example, let’s say your overhead rate is $10
per man-hour and the job you’re estimating is much
larger than average. You might want to estimate this
job with an overhead rate of $9 or $9.50 per man-hour,
instead of $10.
Now, let’s say the opposite condition occurs, and
the job is much smaller than your average project.
Under this condition, you might want to estimate the
job with an overhead rate of $10.50 or $11 per manhour, instead of $10.
Contractor size. Smaller contractors have a higher
overhead rate per man-hour as compared to larger
CONTRACTOR SECTION
ones, because a large electrical contractor is able to
distribute its overhead cost over a greater number of
man-hours.
The small electrical contractor cannot be price
competitive against a larger electrical contractor. This
is because small electrical contractors need to pay
premium wages and they must provide the same benefits as the larger contractor in order to keep employees
because of limited advancement opportunities. In
addition, smaller contractors have limited purchasing
power and their overhead cost per man-hour is higher
(because the number of labor hours available to distributed overhead is less).
Determining the break-even cost. Now that we’ve
decided which method to use for applying overhead,
let’s finish calculating the break-even cost. The table
at the top of the page demonstrates how to determine
a job’s break-even cost using the cost per man-hour
method for overhead. Let’s assume the following:
Labor: 97 hr to complete at $19.76 per man hour.
Material: $3955, including quotes and taxes.
Other cost: $100 for permit fees.
Overhead: $10 per man-hour.
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July 2001 • EC&M • www.ecmweb.com
At this point, it’s natural to worry that you won’t get
the job if you consider all of these factors. But remember—you are only determining what you think the
project will cost you. If you don’t think you can sell
the job for what it costs you, you’re left with only a
couple of options.
• Sell the job for less than it costs you (not a good
option), or
• Become more efficient and effective so you can
reduce break-even cost.
Once you have completed the estimate by determining the break-even cost for the job, you are
ready to come up with a bid price by determining
the job’s selling price. We’ll cover this subject
next month.