BLOG: On The Level

[#1]

Many contractors have been taught to think of their field equipment as an overhead cost. Accountants and bookkeepers will routinely set up the chart of accounts with field equipment costs included as overhead. This is a very common practice in the manufacturing industry, where Cost of Goods Sold includes only the raw materials used to manufacture/create finished products, and all facilities and equipment are counted as overhead costs. However, as a contractor, this common practice can hurt both your sales and your profits. 

When you include equipment costs in your overhead budget, then you are averaging out those costs and charging this average to all your clients. Theoretically, this can work, but it really only works under certain conditions:

·         You use an overhead recovery system to recover overhead costs

·         You hit your sales goals and manage your overhead costs

·         All your jobs use very similar equipment

Based on these conditions, you can be reasonably sure that you’ll recovering equipment costs as overhead will work for your company. 

But this method will fail you if your jobs use different types and sizes of equipment.  When you recover all your equipment costs as overhead, you are charging each customer the average cost of your equipment on every job. The problem with this is obvious; you’ll only price the job accurately if the job uses exactly the average amount of equipment.

If your job requires less equipment than the average job…

…you’ll over-price the job. If you price the job based on average equipment costs and the job requires little equipment, then you’re inflating your selling price by including too much equipment costs in your bid. If you’re bidding against a company who bids each job with specific equipment, your price will likely be higher than theirs (all other costs being equal) and they’ll stand a better chance of winning the bid.

If your job requires more equipment than the average job…

…you’ll underprice the job. You won’t recover enough of your equipment costs because you are only recovering your average equipment costs on a job with greater-than-average equipment costs. If you bid against a company who bids specific equipment into work, your price will be cheaper and you’ll win the work – but the extra costs of the equipment will come out of your profit! Your job profits will be less than expected because your profit will have to pay the difference between the average cost of equipment and the actual cost of equipment on that bid.

Either way, including equipment costs as overhead hurts your business. If the job equipment costs are anything different than the average, you’ll either over-price the job (potentially costing you the sale) or underprice the job (cutting into your profit).  You’ll end up winning lots of work that you’ve under-priced, and very little work that you’ve over-priced.  It’s a big reason so many companies never achieve the profit they expect – and they might never know exactly why.

Some companies can get away with charging equipment as overhead. If you have four crews on the road and each crew is equipped with a very similar set of vehicles and equipment, then the average (overhead) method can work. For instance, if you only do grounds maintenance and each crew/job is equipped with the same truck, trailer, mowers, etc., then the impact of costing equipment as overhead will be low. Since every job uses an “average” amount of equipment, the impact of costing equipment as overhead is very low. 

However, if you work on contracts where equipment varies, you are costing your company sales or profits or both by budgeting your field equipment costs as overhead. Instead, you need to calculate the hourly or daily operating costs of each piece of equipment and build these costs directly into your estimates. Switch to building specific equipment into your estimates and you’ll:

• Price jobs more accurately
•  Increase your chances of achieving your target profit margin
• Create a better work plan (that includes equipment requirements) for your crews, based on the estimate

Cat is proud to be a partner with Landscape Management Network (LMN). LMN offers members the tools and the training to build accurate budgets, create profitable pricing strategies, and to link estimation and pricing directly to their budgets. For more information, go to www.landscapemanagementnetwork.com.

How have you used your budget to better manage your business? Please share your comments below.

[#2]

Since we do little as part of landscaping, unless it means ripping out railroad tracks, or related railroad structures, and then reclaim the land; our pricing reflect the amount of work involved, including propsed remedial landscaping.  None of the equipment we use is included in our bids; except as an informatory.  We make our bids based on how much time will be involved, the amount of materials we hope to gain from the project, and the end use of the land; whether the railroad keeps control, or the land goes to the farmer, the county, or the state; or any other interested person/company.

Our equipment is paid for through the profits we generate from working our contracts, and these payments are not based on what we bid the projects in at.  Since we are using, for the most part, equipment which is several years old, which we keep in good shape, we are able to bid projects less than much of the competition, as our equipment costs are not considered, when it comes to making a bid.  But that is only due to the fact, that not every piece of equipment, which may start a project, will be on site when the project is over.

I did check out LMN, but I don't think they have any thing we can use when it comes to our project bidding process; mainly as we are not doing much in the way of landscaping.

[#3]

Spreadsheet templates that allow you to input values for specific conditions can calculate your fully operated cost / operating hour, for each base machine and work tool.  This can be a handy tool in many bid situations. 

[#4]

Don't forget that accounting for equipment costs as overhead removes direct responsibility that field supervisors have to control equipment costs. As long as equipment costs are averaged across the company, a project manager can abuse equipment and never really get a sense for how much it impacts his job costs. Here's a story that argues for allocating overhead to jobs according to labor hours logged that could help put some accountability back into the system -- How To Allocate Overhead To Projects. This approach offers a competitive advantage over many contractors, but I suspect the author would advocate separating equipment from overhead in the ideal world.