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.

By Mike Holt, Mike Holt Enterprises, Inc.

N ow that weve discussed the list of expenses you must include in any
estimate, its 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 esti-
mated prime cost based on previous articles in this magazine.
Continued on page 44

Figure 1

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CONTRACTOR SECTION

Continued from page 40

Where finding the prime cost is a relatively basic
operation, overhead can present some complex chal-
lengesparticularly in its applications. If applying
overhead to the job isnt the most difficult step in the
estimating process, its at least one of the most intimi-
dating. 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, ben-
efits, 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-per-
hour method.
Although its the most popular method, using per-
centages to find overhead can get you into trouble.
Most contractors apply overhead to a job as a percent-
age of prime cost, and in many cases they dont 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!
Lets 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% (percent-
age of sales) for the multiplier for overhead and 5% for
profit.
This method is
wrong because the
25% listed for over-
head and the 5% for
profit on the income
statement are based
on a percentage of
sales, not a percent-
age of prime cost. Because you dont know what the
job is going to sell for, you cant 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
your break-even. The table above demonstrates how
to correctly determine overhead.
If you have been in business for awhile and it seems
like youre not making much money on the jobs you
complete, then this is one area you need to discuss with
an accountant. Its possible youre 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 dont want to
include it twice! Most electrical contractors do not
separate labor burden cost from overhead in the in-
come 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 youll know what percentage
to apply to burden. Then you can simply apply over-
head 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 man-
hour 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

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CONTRACTOR SECTION
Other factors to consider. When applying over-
head, 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 over-
head 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%, over-
head can only be reduced by 10%. The new overhead
rate per man-hour will be $11.25.
Now, using the overhead rate, lets 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
46 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 con-
sider 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, lets say your overhead rate is $10
per man-hour and the job youre 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, lets 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 man-
hour, 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 ben-
efits 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 dis-
tributed overhead is less).
Determining the break-even cost. Now that weve
decided which method to use for applying overhead,
lets finish calculating the break-even cost. The table
at the top of the page demonstrates how to determine
a jobs break-even cost using the cost per man-hour
method for overhead. Lets 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.
At this point, its natural to worry that you wont get
the job if you consider all of these factors. But remem-
beryou are only determining what you think the
project will cost you. If you dont think you can sell
the job for what it costs you, youre 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 deter-
mining the break-even cost for the job, you are
ready to come up with a bid price by determining
the jobs selling price. Well cover this subject
next month.

48 July 2001 EC&M www.ecmweb.com