A contractor from Arizona and I were having a conversation in which he told me he added 30 percent to his labor costs for overhead. “How did you come up with 30 percent rather than any other percentage?” I asked.
As he thought about my question, he realized he had no valid reason for choosing that percentage. Whenever I hear contractors use a set percentage to calculate their overhead costs, I cringe.
Except for pure luck, using set percentages does not reflect actual cost. Percentages should not be used as a formula to arrive at your overhead cost. They are the answer after you have properly calculated a budget using dollars and cents. A percentage only reflects that portion of a selling price allocated to labor cost, overhead cost, material cost and profit, if any.
You might wonder why I calculate the overhead cost in terms of dollars and cents rather than percentages. As a young apprentice, I worked for a PHC contractor with a large crew who installed plumbing, heating and cooling systems for sizeable new construction projects. To get his final payment for the project, the developers had him address problematic items associated with the work our company had done.
Knowing I could diagnose situations and remedy problems, the contractor gave me a punch list of those items, a truck, tools and forms called extra work orders so I could record the time and materials I used to address each item.
The form was simple enough. It had sections for consumer information; job location; services performed; time spent; the material used; a predetermined overhead percentage; a predetermined profit percentage; and summation of charges.
When my boss was responsible for the work done, he had documentation for his records. But sometimes the work I performed was not my employer’s responsibility. In which case, he would charge the developer for the services I performed based on the information in the extra work order.
The first time I used the form I calculated the time spent and multiplied it by the hourly cost for labor. I summed up the cost of material and added the two factors. Then, I noticed a flaw in the overhead and profit sections of the form. According to the form, I was supposed to add 10 percent to the cost of labor and material to cover the overhead expense, as well as 10 percent for profit.
I wondered how my boss knew that 10 percent of the cost of labor and material would cover his actual overhead expense. As to the 10 percent for profit, profit dollars only exist if there is a profit above the true cost of labor, material and overhead. If you underestimate any of those factors, your profit, if any, is directly affected.
Doing the Math
Labor costs include the actual salary paid and the expenses related to salary, such as FICA matching funds; unemployment and disability insurance; worker’s compensation insurance (or insurance in case a sole operator becomes unable to work); liability insurance related to payroll; vacation and holiday pay; health insurance; and retirement funds.
If you only paid a tech $15/hour as a direct gross salary, your labor cost per hour with those additional labor-related expenses would be at least $30. The number increases dependent upon the number of tech hours actually sold.
Overhead costs include vehicles and vehicular-related expenses (such as depreciation/replacement of vehicle, financing, insurance, fuel, repairs/maintenance, inspection/registration); administrative expenses for office personnel and related ancillary expenses (such as rent, utilities, office supplies and equipment, phones, advertising, etc.); professional services (such as legal, accounting and consulting services); and miscellaneous expenses (such as customer relations/callbacks, bad debt, breakage and loss, tools, licenses, education, dues, uniforms, bank charges, etc.); as well as unforeseen items (such as illness, accidents, premature equipment failure, etc.).
Those overhead costs for PHC service contractors usually range between $75 and $150 for each tech hour. It’s not 10 percent, 20 percent or 30 percent. In relation to the aforementioned minimum salary of $15/tech hour, that’s between 250 percent ($75 ÷ $30 = 2.5 times the labor cost) and 500 percent ($150 ÷ $30 = 5 times the labor cost). That’s why you must remember you pay for your business expenses in dollars and cents — not percentages.
Business forms that give you set percentages for overhead expenses, but don’t cover your true cost of overhead are flawed. And predetermined profit markups and margins based on flawed overhead costs do not allow you to make the profit you want. Don’t be fooled by forms that predetermine overhead costs and profit with erroneous factors.
Figure 1 shows varying percentages of overhead in relation to labor costs starting at $25/tech hour salary and increasing in $5 increments up to $50/tech hour. Overhead costs start at $75/tech hour and increase in $15 increments up to $150/tech hour.
At $25 of salary expense and $75 of overhead cost, Figure 1 shows the overhead cost is 300 percent of the salary expense ($25 x 300 percent = $75). But at $50 of salary expense and $75 of overhead expense, the overhead cost is only 150 percent of the salary expense ($50 x 150 percent = $75).
Your overhead is in a constant state of flux. The items and services you purchase to run your business can usually increase at any time. This, in turn, will cause the percentage of overhead in relation to whatever number the percentage is based on to change.
Figure 1 illustrates that, as the dollar cost of overhead items and/or services rise, the variable percentages of the actual overhead cost in dollars changes. At the $25 level, a $15 increase in cost to your dollars makes the percentage change from 300 percent to 360 percent.
Wrong numbers can only produce wrong results. Wrong formulas and flawed procedures, such as using a predetermined set percentage to calculate overhead costs, produce the wrong numbers.
Figure 2 shows a task that will take two hours of your time and has a material cost of $50.
At a 50 percent margin to cover overhead and profit and a $25 hourly salary, the selling price would be $200 (shaded yellow area). But if the overhead cost was $75/hour, your cost would be $250 (red number) and your result would be a loss of $50 (shaded red area). At $150/hour of overhead cost, your loss would be $200 (shaded red area).
Calculate your overhead by using dollars and cents — not percentages. If you have an opinion or questions on this article or want help with your overhead calculations, give me a call.