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ОглавлениеFinancial Techniques for Profitability
Benjamin Franklin once said:
Beware of small expenses; a small leak will sink a great ship.
While there are numerous reasons why businesses fail, money woes and financing issues rank near the top, especially for companies engaged in contracting. Many contractors fail to correctly recognize their true cost of doing business and thus fail to properly price their services accordingly. It is very interesting to know that in the same geographical area of the country, competitive bids for the same work from several contractors can differ by as much as 30 percent. Does this mean that some contractors deliberately overcharge their clients or that others are giving the work away? Absolutely not. There are typically legitimate reasons for a wide variance among bids for the same work. Contractor A, for example, may have a larger, more stable, and more experienced workforce who demand higher wages, while contractor B may work out of his home, have few employees, and thus have very low expenses. However, contractor C may not truly understand and account for all of his expenses and therefore actually undercharge clients.
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Most software companies offer product upgrades nearly every year. Often, these upgrades offer minor changes to the basic programming. While it is important to keep up to date with the latest software enhancements, money can be saved by upgrading your software every other time it is offered. Study the new features offered by an upgrade, and decide if you can postpone them by a year or so. Caution: If your software becomes obsolete because you skipped too many upgrades, it’s probable that the software company will cease providing technical support for your older software.
Contractors who have a reputation for excellent work that is completed on time and within budget are usually able to charge more than the contractor who is late, installs the incorrect product, and adds “extra charges” when the project is completed. This chapter covers the strategies for establishing a budget and how to use it to calculate a fair and profitable price for services. It establishes the framework for Chapter 7, which explains how to use the budget to determine what level of annual revenues is needed to make a profit.
Creating a budget for a new contracting business, or any business, can be a difficult because of the lack of a spending history. Established businesses have years of spending records to help them estimate future spending. Without a track record, a new business must make educated projections based on the best available information and then actively monitor and update its budget as actual spending information is known.
Assistance may be available from a number of sources, including former employers, industry associations, suppliers, and even some competitors. Asking a large competitor for help might seem like a daunting task, but surprisingly, many large, established companies are eager to help a startup contracting business. They take it as a compliment that someone respects them enough to ask for advice. They have a vested interest in seeing that new businesses in their industry present themselves in a positive light. And, they are so well established that they have few worries about competition from a startup.
The first thing you need to do when considering your budget is make sure you know what you absolutely need in order to make the business work. Often, we have items available that we do not need to buy if we are starting a small one- or two-person operation. For example, in the early stages, your current computer may do the trick, as long as it supports financial and accounting software. In all fairness, budgets can even be made on Microsoft Excel spreadsheets. In fact, some business owners prefer making a simple budget without the complexities found in some software programs. Remember, software is a tool to help you with a budget and with financial matters. You, however, are in charge of the basics, which means knowing how much you are spending and where you are making a profit, or not.
New business owners can save money and keep budget items to a minimum by being creative. Many business owners have used furniture and crates saved in their basements or in the garage as a starting point for their office furnishings and storage.
By using accounting software, a contractor can track expenses, both by category and by supplier; organize client information and accounts receivable; manage employee wages, deductions, and benefits; and accurately file government reports and payments. Four of the highest rated accounting programs for small business are FreshBooks (www.freshbooks.com), Sage One (at www.sageone.com), AccountEdge Pro (at http://accountedge.com) and QuickBooks Pro by Intuit, Inc. (at http://quickbooks.intuit.com/). There are versions available for both the PC and Macintosh.
There is another invaluable tool that becomes the heart of the budget-making process—the spreadsheet.
As you will learn later in this chapter, the spreadsheet is helpful with financial management because it can be used to understand the effects of increased or decreased spending. For example, the spreadsheet can be used to answer a question like, “If I hire a salesperson and increase total wages by $25,000, how much will the cost of employee benefits increase and how much more revenue will I need to generate this year to pay for these increased costs? OK, now what happens if the person I hire wants to be paid $35,000?” All the budget maker has to do is enter either amount of the new wage, and the questions will be automatically answered. It’s a great tool for all sorts of “what-if” questions.
Establishing a budget for your business is a key ingredient to success. A contracting company may have the most skilled employees, the newest equipment, a top-notch sales team, and a creative advertising and marketing program; but failure is destined if the company does not have a comprehensive financial plan. The budget is the first step in creating this plan because it:
Helps plan for the future
Helps plan and manage your money
Helps identify problems before they occur or get out of hand
Helps you meet your goals and objectives
Improves the decision-making process
Increases employee motivation
Helps keep costs under control
tip
When establishing a budget, weigh the costs and benefits of your spending decisions. For example, let’s say you plan to buy a piece of equipment for $10,000. However, the dealer has another model that is larger, faster, and more efficient at a cost of $14,000. Ask yourself if the additional cost of $4,000 will generate a net benefit to the company of at least that much. If it does, buy the more expensive model. This concept of marginalism shows that additional (marginal) costs and additional (marginal) benefits are pertinent to financial decision making.
Although the budget can be considered a road map to financial success, the road is littered with potholes and detours. Never consider your budget to be a fixed document that you prepare once and never change. It is a dynamic document that will undergo revisions and modifications during the year. Most often, these changes will be minor, with little effect on your overall financial plan.
Many new business owners begin their budget process by trying to determine what their total revenues will be for the year. They think that by considering revenues first, they’ll be in a position to know how much money they can spend during the course of the year. What they often overlook is consideration of how they will achieve the projected revenues. Merely knowing or guessing annual revenues does not provide a strategy for pricing your services nor does it instill any kind of spending discipline. Projected revenue is something you cannot necessarily control, since you do not know how many jobs you will get and how much of that revenue may not occur based on factors that are out of your control, ranging from a recession to weather conditions to a major competitor opening in your area of business.
Conversely, spending is something that you can control. You can decide how much you’d like to spend while knowing your minimum needs. Sure you might like a large office space, but you might be better off taking a more realistic approach and budgeting for a moderate-size office.
The budget process begins and ends with a detailed and organized system that projects annual spending in various categories and then uses these spending amounts to determine the amount of revenue needed to pay for the spending, leaving enough at the end of the year for a profit.
The sample budget used in this chapter will be divided into three distinct categories of expenses, each with its own unique characteristics. The first category contains direct job costs, or just direct costs, expenses specifically related to projects completed by the company. It includes materials, labor, and subcontractors, if any; it also includes the rental of any equipment that might be required to complete the projects.
One of the most difficult concepts for new contractor-owners to grasp is the true cost of labor. An employee earning $10 per hour actually costs his or her employer much more than that. In addition to the hourly wage, the employer incurs costs in the following categories:
Social Security and Medicare taxes
Unemployment taxes, both federal and state
Workers’ compensation insurance
Paid holidays and vacations; sick days
Health insurance premiums
Overtime
When you combine these costs, which we call the “labor burden,” you’ll get a truer picture of your actual cost of doing business. Most businesses have different classes of employees, such as the field laborers who install the projects, the sales force, and the office staff. Each category will have a slightly different calculation for labor burden. For illustration purposes, imagine a contracting company that works 52 weeks per year, has six field laborers, one office worker, and an owner who handles sales, design, and general administration of the business. The charts that follow reflect this imaginary company, K&K Contractors LLC. However, the concepts work well with companies of all sizes and configurations.
tip
Hiring subcontractors is a very popular manner of bringing in staff for projects because it saves money in many ways. Not having to pay benefits allows you to pay at a higher hourly rate and still save money. You are also not carrying a higher payroll during slower times of year. Plus you can bring in experts in areas you may not need on an ongoing basis. Look for trustworthy and competent contract employees.
When compiling the information needed to complete the calculations, some projections will have to be made. You can never truly know the future, but you can make rational estimates.
Take a look at the Figure 6–1, “Labor Burden Calculation for Field Labor,” on page 69. At the top of the chart, total annual regular wages are listed for six employees. The totals are based on a year of 50 working weeks of 40 hours each. The remaining two weeks of the year are reserved for vacation time. Our hypothetical company, K&K Contracting LLC, has a total yearly field payroll of $187,500.
The bottom portion of the chart lists the various taxes and benefits. These are costs that relate directly to the wages of the contracting employees who work at job sites. Office personnel, sales staff, and executives are not included (unless the latter work regularly with the work crews at the job sites).
Every contracting company will have a slight variation from this chart; every state has its own rates for unemployment and workers’ compensation, and general liability. The various taxes and benefits of K&K Contracting are:
FIGURE 6–1: Sample Labor Burden Calculation for Field Labor, K&K Contracting
Social Security and Medicare taxes. Employers and employees each pay these taxes. The employer’s portion for Social Security is 6.2 percent of an employee’s wage, up to an annual limit set by the federal government. For 2015, the wage limit was $118,500, meaning that the maximum amount an employer must pay for one employee is $7,347. The employee’s portion is 6.2 percent of his or her wage. There is no maximum wage limit for Medicare taxes, which have a rate of 1.45 percent for the employer. Employees pay the same amount, which is deducted from their paychecks and sent to the government by the employer.
State unemployment tax. The tax rates are established by individual states and vary widely. Taxes are usually paid by the employer and not deducted from an employee’s paycheck. Most states have a range of rates, so employers who lay off more employees incur a higher tax rate, which also points in favor of subcontractors rather than a lot of full-time employees. Again, most states have a taxable wage limit; after an employee’s annual wage exceeds a certain amount, unemployment taxes are no longer charged to the employer. A few states offer an exemption to certain owners of the business; however, care must be taken with this option as it may result in higher federal unemployment taxes.
Federal unemployment tax. This tax is fairly simple and straightforward for most employers. The tax rate, as of 2015, is 6.0 percent of the first $7,000 of each employee’s wage, but most employers receive a credit of 5.4 percent when they file their Form 940, resulting in a net tax of 0.6 percent, or $42 per year.
Workers’ compensation. Once again each state has its own laws governing workers’ compensation insurance, which provides coverage for employees who are injured on the job. While the states set the rates, usually in dollars per $100 of payroll, insurance companies sell the product. These insurance companies are in competition and can offer to pay a dividend (return of premium) to companies who have excellent safety records. Rates in contracting and construction are typically very high due to the risk of injury on job sites. However, dividend payments can be as much as 50 percent of the annual premium.
General liability. The premiums for this insurance are based on payroll and vary from state to state and from contractor to contractor. The insurance covers several items, but the two most important features insure against damage to a client’s property and against injury or harm done after a project is completed. For example, if an employee backs a vehicle into a client’s garage, the general liability insurance will cover the damage; or if someone trips on a step installed by a contractor, general liability insurance will provide some protection against lawsuits and should pay for repair.
Paid vacations and holidays. While these are actually employee fringe benefits, they are expected by most employees. Employers who do not offer these benefits risk losing employees to competing businesses.
Health insurance premiums. Health insurance is a hot button-issue these days and is often the single largest annual expense for a small business. The health insurance industry is very complex and in a constant state of change. Therefore, contractors should consult with independent insurance agents who specialize in the field. This is certainly an area where one size does not fit all. Insurance agents can shop around to find the best plan for each contracting company. Typically, employers ask each employee to contribute a portion of the premiums.
Overtime. Unless a contractor can charge its clients extra when an employee works more than 40 hours per week, the cost of overtime should be included in the labor burden. In the case of K&K Contracting, each worker is estimated to work 44 hours a week for 40 weeks and 40 hours for the remaining 12 weeks of the year. The federal government has ruled that in general, employers must pay a wage of one-and-one-half times a worker’s regular wage for each hour over 40 worked in one week.
warning
Some employees must be paid overtime even if they are paid a salary. The rules are complex, so make sure you understand which of your employees must receive time and a half when they work more than 40 hours in a week.
As we see in Figure 6–1, the total labor burden for K&K Contracting LLC is just over $79,000 per year for its six employees. Therefore, the annual labor costs are far higher than the regular wages paid to employees. But how is this information useful to the budget and estimating process? Simple, really. You calculate the labor burden’s cost as a percentage of total field payroll by dividing the labor burden by the total payroll as follows:
$79,239 ÷ $187,500 = .421 = 42.1
As indicated earlier, labor costs are only one part of direct costs; the remainder includes estimated annual costs for materials, equipment rental, and subcontractors. In Figure 6–2 (page 72), we’ve set up a hypothetical direct cost budget for K&K Contracting.
Astute readers will notice that the cost of labor listed in the direct cost budget, given in Figure 6–2, ($101,250 + $67,500 = $168,750), does not equal the total annual wage ($187,500) listed on the labor burden worksheet, Figure 6–1. The reason for this is that we are reserving 10 percent of the cost of labor for what is called “yard time,” which is the cost of paying employees when they are not on the job sites generating revenues. They may be maintaining equipment, taking part in staff meetings, attending job-related seminars, on break, or performing warranty work. Every company will have its own calculation for yard time. But for the purposes of this book, we’ll use 10 percent (about four hours per week, average, per employee).
Therefore, K&K Contractors expects to spend approximately $600,000 for materials and labor that are used expressly for the projects it works on. We’ll save this amount for now and come back to this after we set a budget for the other two categories of spending.
FIGURE 6–2: A Sample Direct-Cost Budget
Every business has costs that it incurs regardless of the level of business activity. These are amounts due on a regular basis and are fairly constant from one year to the next when adjusted for inflation. Fixed costs include expenditures for items such as:
Officer and office salaries
Interest expense
Rent and utilities
Telephone service
Advertising and marketing
For example, a company pays a fixed amount of rent each month for its office space regardless of how busy it might be; it signs a lease agreement for $1,000 per month and must pay that amount whether its annual revenues are $100,000 or $2,000,000. However, some fixed costs may “break the rule” and increase more than an increase in revenues. Telephone service is one example: if revenues unexpectedly surge, a company may have to add additional telephone lines to handle the increased business. But for the purposes of this book, assume that fixed costs will remain relatively constant. However, before the fixed cost budget category is set up, the labor burden for the office staff must be determined. Refer to Figure 6–3 on page 74, which is very similar to Figure 6–1.
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If you find that your business is growing and you have the opportunity to rent a larger space than you currently need, at a good price, you might elect to go for it and split the space with another company or either lease it or sublet it if it’s OK with a landlord.
You can make the same mathematical calculation used in Figure 6–1 to determine the labor burden as a percentage of total office payroll as shown:
$14,769 ÷ $75,000 = .196 or 19.6%
This is much lower than the labor burden for field labor, primarily because workers’ compensation rates are much lower for office workers and because holidays, vacations, and overtime are included in the salaries of these workers. Once again, for every $10 that you pay office staff, you’ll pay an additional $1.96 to the various state and federal governments and for fringe benefits. Putting together the fixed-cost budget results in Figure 6–4, page 75.
Several items in the fixed cost budget need further explanation and clarification.
Bank payments. We include both principal and interest paid for the bank loans secured to buy equipment. Since the budget is concerned with actual spending, We’ll leave income tax ramifications to the accountant.
Capital equipment fund. While this is an optional expense, we strongly recommend establishing a fund to be set to purchase equipment or to make a down payment on a loan for equipment. Companies with very good credit ratings can often secure bank loans for the total purchase price of a piece of equipment. However, by creating a separate capital equipment fund, future principal and interest payments can be reduced, thereby improving the monthly cash flow of the business.
Other items. The fixed-cost budget is fairly simple but realistic for a small business. Some other expenses that companies include as fixed-cost budget items are: employer portion of retirement plans, professional expenses such as attendance at trade shows or seminars, as well as advertising and marketing, association dues, and other employee benefits.
Anticipate. When compiling the information for your fixed-cost budget, remember to include items that may increase later in the year due to other spending. For example, if you plan to purchase a new vehicle in September, remember to add the cost of insurance for the last four months of the year as well as the cost of the license plate.
FIGURE 6–3: A Sample Analysis of Office Staff Labor Burden for K&K Contractors
FIGURE 6–4: A Sample Fixed-Cost Budget Analysis
To review, the fixed-cost budget for K&K Contracting amounts to $187,484, meaning that the company expects to spend that much regardless of the amount of revenues that are generated during the year. It is crucial that the fixed-cost budget be realistic and accurate because not only does it impact the pricing of services, it also helps determine the annual revenue required to make a profit. We’ll come back to the profit issue later in this chapter.
The third category of spending is called variable expenses because items here usually change in real terms, or dollar amounts, as the level of business activity increases. In addition, they tend to remain about the same percentage of direct costs. In other words, if direct costs increase from one year to the next by 15 percent, it is likely that as a group variable costs will also rise approximately 15 percent. An example of variable costs is the cost of travel expenses. When business activity increases, a company is more likely to have employees travel to more work locations for client meetings as well as work on the job. Other items we also include in variable costs are:
Vehicle maintenance and repairs
Office expenses
Office supplies
Printing
Employee incentive or bonus pay
Advertising and marketing
Small tools; hardware
Uniforms
Salesperson salaries and commissions
Depreciation
Did you know that equipment purchases can be depreciated over time, reducing the income tax burden? Depreciation can be a complex concept; we strongly recommend consulting with an accountant in order to receive the most favorable benefit from depreciating equipment.
An excellent way to plan for the future is to prepare a chart listing all of your depreciable equipment, such as vehicles and skid loaders, and projecting the useful life of each. Then estimate the replacement cost, adjusting for inflation. Knowing when and how much you will have to borrow for capital equipment is critical to both the current and future annual budget process. Saving for the future takes good planning and great discipline but is well worth the time and effort.
warning
In most states, price fixing of a product or service is illegal. Generally speaking, a company may not, with another company, agree to set a price for a particular product or service. However, conformity of prices for a particular product or service is not illegal unless the conformity was created in combination with other companies agreeing on a set price.
Some costs overlap between fixed and variable. These include items such as advertising. While the cost of advertising on a website may be constant from one month to the next, advertisements in local newspapers or magazines may be placed at irregular intervals—or not at all. The variable-cost budget for K&K Contracting given in Figure 6–5 on page 77 is fairly easy to understand. These are the costs that will change as business activity changes. We strongly recommend including a budget for “contingency.” Unfortunately, you cannot expect the unexpected—as when the United States experienced a jump in the price of gasoline to $4 per gallon. Employee incentives are in the variable cost budget even though they may not increase as revenues increase. However, they are certainly not fixed costs, and it would be a stretch to include them in direct costs. Because they are usually tied to employee performance, the best place for them is with variable costs.
FIGURE 6–5: A Sample Variable-Cost Budget
Well, now what? Direct costs, fixed costs, and variable costs are identified as the major components of a budget. This is all well and good, but what does it tell you, and how can you benefit from the knowledge gained from compiling these budget numbers? First it’s a valuable exercise that forces a business owner to correctly identify all of the costs of doing business. But more importantly, you can use the information to assist in setting prices for your products and services.
Now that you’ve identified three categories of spending, the next step is to combine two of them and give them a new name. Each will keep its own identity, but they work together to make what is called “overhead,” which is the ongoing general and administrative expenses that are not directly related to the selling of a company’s goods and services. To that end, you’ll combine fixed costs and variable costs to calculate total overhead expense. Using the example of K&K Contracting, combining these costs gives the following results:
Fixed costs = $187,484 + Variable costs = $ 86,120 = Overhead = $273,604
One way to consider overhead is that it supports direct costs. When money is spent specifically to generate revenues (direct costs), money is also spent in the office and elsewhere to support those direct costs. The budget you are developing will help you determine how you will generate revenues to pay for or to recover overhead expenses. The first step is to understand the relationship between direct costs and overhead. Consider this formula:
Total overhead ÷ Direct costs = Overhead recovery percent
And when we plug in our numbers:
$273,604 ÷ $597,293 = .458 or 46% = Overhead
What this means is that for every $100 spent on direct costs an additional $46 will be spent on overhead. With a little experience, it is fairly easy to determine the cost of materials for a project as well as the time estimated to complete it. Once this is accomplished, the cost of overhead recovery falls right into place.
Alternative Method
Some contractors, either by preference or because the competition demands it, allocate overhead only to their labor costs. In the case of K&K Contracting, when overhead is allocated to labor only, the overhead recovery rate is 114 percent ($273,604 ÷ $239,793). This may be acceptable for some companies, especially if the relationship between materials and labor is relatively constant. However, when the cost of materials is extremely high relative to the cost of labor, the result is usually to undercharge the client. The reverse is usually true when the cost of labor is high relative to the cost of materials.
In Figure 6–6 on page 79, the costs of four separate projects are presented using two different methods. Method A allocates overhead evenly between materials and labor, while Method B allocates overhead to labor costs only. As can be seen by the results, Method B shows no constant relationship to Method A: Differences range from +39 percent to –7 percent. Regardless of the inconsistencies, we recommend testing these methods both internally and against the competition to determine if one of the methods is preferable to the other. In fact, different divisions within one company might use different methods. A key factor is to remain competitive with the other contractors in your area while making a reasonable profit.
FIGURE 6–6: Comparison of Overhead Recovery Methods
The break-even point is the point at which you are now covering your expenses with income. It’s important to know how much you will need in business to break even and recognize when you have reached that point. It often takes businesses a number of years before they show a profit; this is the turning point.
Refer to Figure 6–6 and study the data for Project A, Method A, numbers we will use for the remainder of this book, which indicates a break-even point of $722. This includes the wage costs and associated labor burden to complete the project as well as all the overhead related to these direct costs. As long as the costs stay within this budget, the company will begin to make a profit when they receive more than $722 for the project.
Let’s summarize the annual budget by combining the information gathered in Figures 6–2, 6–4, and 6–5. These include all of the anticipated costs of doing business during the entire year. In the next section, we break out the numbers and show how to prepare an estimate for an individual project. Following is the summary of the charts.
Fixed costs and variable costs are the components of overhead because they are the expenses that support the direct costs, the expenses directly related to the implementation of projects. As indicated earlier, total overhead in this case is 46 percent of direct costs. At this point, the level of total costs is useful only to give a general indication of how much revenue will be required to break even. However, this is true only at the level of direct costs indicated in Figure 6–2 (page 72). Chapter 7 covers the concept of contribution margin and the revenues required to generate a profit.
Preparing an estimate for an individual client can be a relatively easy task once an annual budget has been set and the cost of materials for the project determined. The only other major piece of information required is the amount of labor required to complete the project. The best way to do this is to make a chart of all the individual tasks your company does and assign a time budget for each. Each task should indicate the units involved (each, square feet, cubic yards, etc.) and the time required for a single employee to complete the task. Refer to Figure 6–7 for an example from a hypothetical landscape contracting company.
With this information in hand, you can begin to develop an estimate. We’ll go through the process step by step using the following information. Upon completion, we’ll use a spreadsheet to calculate a price for the job.
Calculate average crew wage.
Compile list of materials needed for the project.
Refer to the time-per-task chart.
Find the labor burden and overhead recovery percentages.
Decide the desired profit.
Figure 6–8 on page 82 demonstrates a simple estimate using the spreadsheet:
Column A is a list of the materials and tasks planned for the job.
Column B indicates the unit associated with Column A.
Column C shows the total quantity of each unit.
Column D is the individual cost of each item.
Column E is the total material cost achieved by multiplying column C by column D.
Column F indicates the time it takes for one worker to complete one task; see Figure 6–7.
FIGURE 6–7: Sample Worksheet for Time Required Per Task
FIGURE 6–8: Example of a Simple Estimate
Column G shows the total time to complete all tasks; Column F times Column C.
Row 9 shows the totals of both the materials and the time required to complete the project.
Row 11 indicates the average crew wage (see below).
Row 12 indicates the total wage cost, including the labor burden calculated in Figure 6–1.
Row 13 is the total direct cost for the project.
Row 15 is the cost of overhead from page 75.
Row 16 is the sum of Row 18 and Row 20, showing the break-even point of the project.
The average crew wage needs a bit more explanation. Step 1 is to add the wages of the individual workers expected to work on the project and divide by the number of workers; Step 2 adds the labor burden. The concept is to find an average crew wage because this ties in directly with the information from Figure 6–7. An average crew wage is the average paid to one worker while the time required per task is the amount of time required for one worker to complete the task. If K&K Contracting decides to place one two-person crew on the project, the wages of the two workers are $18.75 and $12.50:
Step 1: ($18.75 + $12.50) ÷ 2 = $15.625 per hour = average crew wage
Step 2: $15.625 × labor burden percent from Figure 6–1
$15.625 × .421 = $6.58 = average labor burden per employee
$15.625 + $6.58 = $22.21 per hour = average crew wage
Therefore, we entered $22.21 in Row 11 of the spreadsheet and used the time per task information to calculate the total cost of labor for the project (Row 12).
The method used in this example is very beneficial because it can be used even if the number of workers on the project changes. Using the spreadsheet, it was determined that it will take one worker 22.60 actual hours to complete the project; with two workers the project should be completed in 11.30 actual hours. Should the owners decide to add another two-person work crew, they’d be free to do so without worrying about the effect on the bottom line.
“The worst crime against the working people is a company which [sic] fails to operate at a profit.”
—SAMUEL GOMPERS, WHO FOUNDED THE AMERICAN FEDERATION OF LABOR IN 1886
Efficiency
Budgeting is one thing, but spending is another. For example, you may have budgeted $5,000 for advertising and marketing. The question is which is the most cost effective, efficient way in which to spend that money? Major corporations spend a great amount of time determining the most efficient ways of spending money. You want to find cost-efficient ways of purchasing items and paying for services, but you will also need to determine how these choices will or will not benefit your business. Like playing a game of chess, you need to consider the repercussions of each move before you make it. This makes the difference between efficiently and inefficiently run businesses.
Thus far we’ve discussed only the cost of doing business, without regard to revenues or profits. You’ve learned that there are costs that are directly related to the process of implementing a project; then there are overhead costs, some of which are related to the direct costs and others that will be incurred regardless of the amount of direct costs.
Profit is what you have left over after paying all of your expenses. If you were to study the income statement of a large corporation like the Walt Disney Company, you’d find columns and rows with data showing “gross profit,” “operating income,” “income before tax,” “income after tax,” “income before extraordinary items,” and “net income.” The discussion of these items is left to the accounting professors. The focus here is on net income.
stat fact
According to industry sources, the average net income as a percentage of revenues within the contracting industry ranges from 3 to 5 percent. This means that a company with $1.2 million in revenues can expect to have a net income, after all expenses, of between $36,000 and $60,000.
However, net income is not the only measure of financial success. Investment advisors and specialists consider many factors when studying the financial statements of corporations. Again, it can be a very complex and time-consuming process to understand the profitability and success of a business. For our purposes here, we’ll keep it simple. While every owner must determine what level of profit is acceptable, we’ll use 12 percent as a profit goal when pricing services. Using this as a benchmark will allow for payment of year-end bonuses or dividends, upgrading buildings and equipment, and building up an emergency fund.
Accounting 101
Accountants, financial officers, and investors study financial statements in many different ways. I’ll touch on three terms that sound similar but are quite different. While there are no “magic numbers,” it may be an interesting and useful exercise to track these ratios on an annual basis. If the ratios increase, you can smile; if they decrease, don’t frown—just work harder and more efficiently.
1. Return on equity equals net profit after taxes divided by stockholders’ equity. It measures a company’s efficiency at generating profits from dollars invested in the business. Return on equity is irrelevant if earnings are not reinvested in the company.
2. Return on assets equals net profit after taxes divided by total assets. It’s an important gauge of profitability as it gives insight into the ability of management to generate profits from the assets available to the company.
3. Return on capital equals net income after taxes divided by long-term debt plus common stock. It is a measure of how effectively a company uses the money, both borrowed and owned, that is invested in the company.
The question is how to determine the price to charge and make a 12 percent profit. If you refer to Figure 6–8 on page 82, we see that the break-even point for the project is $1,996. Many people would venture a guess and say “to make a 12 percent profit, just multiply $1,996 by 12 percent and add the two numbers.” Well, they are wrong. If you just read this sentence and shook your head, you are not alone. Now read the next sentence carefully and memorize it:
To make a 12 percent profit on a project, divide the break-even point by one minus the desired profit (shown as a decimal).
Read it again. To make a 12 percent profit, you divide the break-even point by 0.88.
An example will make this seemingly crazy mathematical formula make sense. Suppose you sell a product for $100 and make a 10 percent profit; your break-even point is $100—$10, or $90. However, if you add 10 percent to $90, you get $99, $1 short of what you want. However, if you divide $90 by (1.00—.10), you arrive back at $100.
Now go back to Figure 6–8 with a break-even point of $1,996. To charge enough to make a 12 percent profit, you divide $1,996 by 0.88 and come up with a final cost of $2,268.
Many new businesses fail because they fail to properly manage their finances.
Establishing a financial budget is a key ingredient to business success.
Computer spreadsheets are invaluable tools for establishing a budget.
The true cost of labor includes payroll taxes, government-mandated insurance, employee benefits, and overtime.
Overhead comprises fixed costs and variable costs.
Pricing systems must be designed to recover overhead expenses.
Three elements determine the final price to the consumer: direct labor and materials costs, overhead recovery, and profit.
Profits are not made until revenues reach, and then surpass, the break-even point.
