Increasing profitability is not achieved by increasing sales; it’s achieved by making sure profit is earned on each job taken in.

During slowdowns in the construction industry, small and medium-sized contractors are usually the first to feel the pinch. Unlike larger companies, they generally lack the financial resources necessary to ride things out until the economy rebounds (which it eventually will). Many are tempted to bend basic business management rules just to keep business in the pipeline. Accepting work at or below one’s break-even point is an all-too-common example of that.

To a business owner in crisis mode, such practices may, on the surface, make sense. It does get business in the door, after all. However, it doesn’t ensure a given job will be profitable. Of course, when it comes to a company’s long-term viability, maintaining profitability on every project is of primary importance. Increasing one’s profitability is not necessarily achieved by increasing sales; it’s achieved by making sure that a profit is earned on each job taken in. To do that, owners need to maintain their focus on the critical variables of their business, and one of the most important of these variables is a company’s overhead burden.  

Managing Overhead
A company’s overhead burden is the fixed costs of doing business. Fixed expenses – also referred to as general and administrative costs – include rent, insurance lease payments and depreciation. As the name implies, these expenses remain relatively stable month-to-month.

Since fixed costs are significant, a good business owner continually strives to keep them at a reasonable percentage level. That’s harder than it sounds and requires constant vigilance. The managerial challenge here is to prevent the accumulation of unintended fixed costs. Unintended overhead accumulation occurs when variable costs – those expenses that fluctuate in accordance with a company’s sales volume – somehow sneak into the fixed expense column and stay there. If the problem isn’t addressed, it can adversely affect both the company’s profitability and its long-term ability to remain competitive and flexible.

Accumulating Overhead  
The problem of unintended overhead accumulation usually starts out innocently enough. Here’s a hypothetical scenario: Fred owns a small construction company, and business has been slow for months. He prides himself on being a good boss, so instead of laying off his employees during slow periods, Fred finds busywork for them. Unfortunately, he’s running out of ideas, and he worries that he may lose his most-valued workers unless something changes.

So he decides to move Sue, his best hourly employee, into the position of project supervisor. She’s given a salary, health insurance, additional paid vacation time and even a vehicle allowance. In a single stroke, the business has a new fixed expense – one that must be paid, month after month, regardless of whether the company is busy or not.

Fred has also been on a campaign to improve productivity. Two months ago, he purchased a new computer with pricey estimating and AutoCAD software. In the following month, he upgraded the office’s phone and communications system. Singly, these seemed like reasonable expenses, but their combined monthly payments are now crimping his cash flow.

Since Fred’s hard-won profits are no longer available for reinvestment, the groundwork is being laid for an even-more serious problem in the future.  

Lastly, Fred started leasing and purchasing some of the equipment he’d traditionally rented when jobs demanded it. Eliminating those increasingly expensive rental fees seemed like a great way to save money – at first.
Unfortunately, Fred didn’t do a systematic rent vs. lease/purchase analysis. The net result? Fred had moved several more variable expenses over to his growing list of fixed expenses.

The seriousness of the problem became evident a month later, when Fred received his quarterly profit-loss statement. With a shock, he saw the cumulative impact of his seemingly minor business decisions. In a short time, Fred had significantly increased his company’s fixed overhead burden and its break-even point. That means he’ll have to substantially raise his prices to cover those new expenses or significantly increase revenue.

The danger in the latter option is that projects in a tight market tend to be at lower margins. It also means his company won’t be as competitive as before, and that will make new business harder to get. What about the contracts he’s already won?

Since his monthly fixed expenses are higher now, it means his profit margin on current projects will be significantly smaller – at a time when he can least afford it. The long-term prospects for Fred’s company are not encouraging.

Accurate Budget Data
The best way to avoid Fred’s problems is by implementing business practices based on sound management principles and rigorously adhering to them – especially during economically challenging periods when business is slow and competition heats up.

Moreover, to be profitable and to adequately fund growth, a business needs to consistently recoup its overhead costs. Each dollar of revenue a company takes in should be apportioned into one or more of these categories:

• Variable costs or cost of goods – These expenses include labor, materials, sales commissions, freight and equipment rental.
• Production overhead – Typically, these costs include supervisor salaries, sales salaries, tools, supplies and shop or warehouse expenses.
• Administrative overhead expenses – Rent, bank fees, office salaries and depreciation fall into this category.
• Profit – Revenue dollars that remain after all the above expenses have been paid are considered profit.

Create A New Formula
It’s important for business owners to both track and calculate their overhead expenses precisely. Unfortunately, many fall short in this regard. Some use an arbitrary number in their calculations, others rely on gut instinct, and still others employ the traditional “this is how we’ve always done things around here” formula – with predictably unreliable results. The only way to compute overhead with precision is by using current budget data.

Calculating a business’s overhead burden, however, is just the first step. The second task is to recover those expenses. Here’s an example: Company “Z” expects to spend $1 million for direct labor and associated variable cost and $600,000 for overhead in the coming year. So, for every dollar spent on direct labor and associated variable cost, an additional 60 cents is required to cover the associated overhead expenses. To do that, a proportional overhead allowance needs to be included on every job estimate. Finally, the profit figure is added to the total cost. Assuming revenues and expenses are managed correctly and sales reach predicted levels, the company’s overhead costs will be recovered.

What You Don’t Know     
Knowing a company’s break-even point is essential to accurate pricing and bidding. It establishes the minimum amount that must be charged for a project to be profitable. Equally important: It specifies a date when a company can, for competitive reasons, reduce its bids – within a set percentage range – and still make a profit.

A company’s break-even point is expressed both as a dollar figure and as a time in the coming year when the company’s projected total revenues will equal its total projected expenses (total expenses = fixed and variable expenses combined). Anything above the business’s break-even point is considered profit. Below break-even, the company is considered to be operating at a loss. 

Unintended overhead accumulation can have a profoundly negative effect on a company’s break-even point and, ultimately, on its long-term viability. On the other had, when contractors arm themselves with accurate break-even and overhead data and use it in accordance with sound management practices, they dramatically improve their chances for a brighter and more profitable future for themselves, their employees and their families.