July 14, 2023
Jacki Hart If you find yourself asking why you don’t have enough profit at the end of every year, you’re not alone. Many small business entrepreneurs (under $10M in revenue) work very hard on the operations and sales sides of their business, keeping all of the balls in the air to ensure customers receive great service and bills get paid on time. Often, working ‘in’ the business trumps working ‘on’ the business. Herein lies the problem.

We all gravitate to do what we prefer. Most entrepreneurs lean away from ‘the numbers’ and the nitty-gritty decisions that build a healthy balance sheet (and bank account). While operational excellence is important, unfortunately, neither the balance sheet nor overhead recovery factors can perform at their best when left on autopilot.

What the heck is ‘overhead recovery’ (OHR)? It’s the act of making sure that the company’s ‘fixed costs’ are fully recovered in the prices charged to customers for products and services. Notice I said that it’s the ‘act’ of recovering costs. It doesn’t happen automatically, and unless you intentionally add the right percentage to your Cost of Goods Sold (COGS), plus a margin for profit (see last month’s column) into the price you charge customers, you will always fall short of the money you’d hoped to make.

For most entrepreneurs, the business and the value that’s built into it over the years is often their plan to fund their retirement. Whether planning to develop a business for sale, or for making additional acquisitions, taking on partners, or franchising — eventually, the track record of profit and assets acquired determines the value of the business, and how comfortably you can retire. So to get there from here, overhead recovery (OHR) and Return on Investment (ROI) are important.

We commonly refer to numbers on the Profit and Loss (P&L) statement as either ‘above the line’ or ‘below the line’. The ‘line’ is Gross Profit. Gross Profit is calculated from the numbers ‘above’ it on the P&L: Sales minus the Cost Of Goods Sold (materials, equipment, field/billable labour, subcontractors) = Gross Profit.

Depending on how your accountant has set up your chart of accounts, you may have to do a bit of fiddling around with numbers to be able to compare your COGS, Gross Profit and OH Expenses on the P&L (income statement) with the industry standards method. Accountants typically put field labour into ‘expenses,’ below the (gross profit) line. If you want to benchmark alongside your peers, you’ll need to move labour above the line.

Everything in ‘overhead expenses’ should be ‘fixed’ — and not proportionate to sales. Here are a few examples of overhead expenses: rent, utilities, communications (phones, internet, software), small tool purchases, shop expenses, business insurance, professional services, bank charges, management and admin salaries, and vehicles (not billable in the field). Note that truck lease expenses aren’t in this list. If you have one or two trucks leased, it’s okay to include them and their related costs here in ‘overhead’ for a SORS (Single Overhead Recovery) method ‘below the line’. If either your trucks or equipment are financed, their loans will appear only on the balance sheet. If you have a larger fleet, all field trucks, equipment and their related costs should be reported ‘above the line’ in Cost Of Goods Sold.

Let’s use an example on calculating OHR: If sales are $700,000 (100 per cent of revenue), COGS are $455,000 (65 per cent of revenue) and Overhead Expenses (including the owner’s salary or income) are $175,000 (25 per cent of revenue), then profit would be $70,000 (10 per cent of revenue).

So here’s the calculation in this example to price a contract that includes recovering overhead:
Let’s say the Cost of Goods Sold for a soft landscape installation is $2,500 and you want to make 15 per cent profit after recovering all of your overhead. Using the JPL formula I explained in last month’s column (refresh your memory: gfl.me/hbzK), here’s the answer:

$2,500 divided by 0.75
(100% revenue - 25% overhead expenses which is 75% or 0.75) = $3,300.
This is your break-even cost.

Now let’s add your desired profit of 15 per cent:
$3,300 divided by 0.85
(break-even cost divided by 0.85 which
is 100% - 15% or 85%) = $3,882.35.
This is your price to your customer.

If you use the incorrect, but commonly deployed markup method, your price to your customer would be $2,500 x 1.25 (incorrectly adding 25 per cent overhead recovery) = $3,125 break-even price x 1.15 (incorrectly adding 15 per cent profit), your price would be $3,593.75. This would have left $288.60 in the customer’s pocket instead of yours. So, on $2,500 worth of labour, materials, etc., if you don’t properly recover overhead and profit margin, you have fallen short of your profit projections for the end of the year by almost $300 bucks.

Many of you reading this might be glazing over, and you might not have actually read the numbers, thought about them and tried it on your own calculator to see if there’s a typo. And you might not yet have tested this out on your own P&L against your own quotes. I encourage you to suck it up and try.

If you are falling short of your goals, then please reread this, plus my last column which you can find at gfl.me/hbzK . Use your budget for the year, and at the very least, if you don’t have one, then use your Quickbooks Profit and Loss Statement to get your total Overhead Expenses as a percentage of the total sales from last year, and make necessary adjustments to forecast your best guess on how things will turn out this year for Overhead Expenses as a percentage of sales this year.

Recover your company overhead in every charge-out hourly rate, and every material or subcontractor cost you incur on a job. You work hard. You’ve earned it. You just might be lousy at math.

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Jacki Hart CLM
Prosperity Partners Program Manager