This article is based on a webinar we ran recently on managing overhead costs.
As the saying goes, you have to spend money to make money. But without clear visibility and a plan for how much and when to spend, you run the risk of eroding your net profit.
It’s a pretty common story, when businesses grow, owners see the money flowing in and get more comfortable increasing overheads…. and then wonder why their profit has taken a hit.
We are not here to tell you to stop spending – this article is about how to get smarter on your spending decisions so that as you scale and bring on more resources, you continue to grow in a profitable way.
To begin with, let’s clear up the distinction between different types of costs in your business.
For building and construction businesses, the most significant area of spending will be your COGS or Cost of Goods Sold. These are direct costs related to completing a project and include all required materials and labour. Once you know your COGS, you can calculate your gross profit and gross margin by subtracting your COGS from the total estimated revenue for the project. These metrics are the most critical metrics when it comes to measuring the financial success of your projects.
In terms of benchmarking COGS and Gross Profit, builders operating in the residential space should be getting gross margins of at least 20% or more, depending on the nature of the work they do. Custom builds and renovations should be landing projects with margins of at least 25% or more.
Overhead Costs are all of the expenses you incur in running your business that are not directly related to a job. These costs include items like accounting, utilities and rent as well as sales and marketing expenses. Overheads also include labour costs like admin and bookkeeping staff as well as roles like estimators.
Once you know your overhead costs, you can deduct these costs from your Gross Profit to determine your Net Profit figure. This is your profit before you pay tax.
As far as benchmarking for overhead costs and net profit, builders in the resi market should be able to achieve single-digit overheads which should result in Net Profit margins of greater than 10%.
Before we discuss improving your planning for overhead spending, it’s important to know how to track your costs in the first place. Cost Tracking, or what is often called Job Costing or Back Costing, gives you a clear picture of costs incurred for each job and allows you to see how your margins are travelling for each project and across your business.
The cornerstone of cost tracking is the use Job Codes and Purchase Orders to allocate expenses to the corresponding job in your estimating and project management software (e.g. Buildxact). It is also important to allocate costs to the correct account in your accounting software so that you can clearly see the breakdown of COGS and Overhead Costs.
Labor costs and Wages are one of the biggest expenses when running a business and an area that can make the difference between running profitable projects and running at a loss.
We like to think of COGS and Overhead wages as being either Earners (wages that contribute to bringing revenue in the door) or Burners (overhead related roles not tied directly to project delivery).
It’s obvious to say that you can’t deliver a project without your Earners, but if you’re going to scale your business Burners are equally important. These roles are often the areas that owners take on themselves when they start out but as you grow and become clear on where to get the best return on your own time and expertise, it’s critical to invest in roles that will give you back capacity to add higher value to your business.
For most costs it’s pretty easy to determine whether they are a COG or Overhead, however items like Owners Wages can be tricky, particularly if you’re an owner who is still working on-site as well as performing overhead related activity like Sales and Estimating.
There a few ways to split your wages if you are doing a mix of work. This can be done either via time sheet entries or a journal entry at the end of the month in your accounting platform. If you need help with this, please feel free to book for a free consultation here with our bookkeeping team.
It’s good to be in the habit of setting up a regular review of fixed overheads like electricity and insurances, so that you’re getting the best rates you can but also due to rising costs in these areas. Something as simple as a recurring reminder in your calendar could be all you need to trigger a review and in some instances, make considerable savings.
In reality, saving on your electricity is not going impact your net profit anywhere near as much as decisions you make on hiring staff, particularly those that are not directly related to a project.
One of the key things to consider and a way to help determine the timing of adding staff, is to calculate the additional revenue required to cover the cost of employing someone like an Estimator.
Critically, when you add overhead wages to your business, these roles should have a positive impact on your profit – that is, you don’t want your profit margin to go backwards or stay the same. If handled properly, these roles should improve the quality of your earnings and improve profit margins if you are calculated in your approach.
Example: Bringing on an Estimator
Using some nice round numbers, let’s say your current turnover is $5 million at 20% GP with overhead costs of 10%. This means you have a Net Profit of 10% or $500,000.
You’re looking to take on more projects but feel that you’re spending too much time on estimating and not enough on the sales side of the business. You decide to take on an estimator at $120,000 PA including super to free up your time.
If your turnover stayed the same, your net profit would be reduced to $380,000 or 7.6%. Not a great outcome!
To cover the cost of your estimator and maintain your current Net Profit Margin, you need to bring in additional revenue to the tune of $600,000 – which, depending on the type of work you do, could be another 1 or 2 projects.
In terms of the impact to your earnings, if having an estimator freed you up to bringing in $600,000 in additional revenue, and keeping a close eye on GP, your Net Profit would remain at $500,000.
This is a good outcome, but a great outcome would be to have a goal of increasing your net profit margin by bringing in even more additional projects OR adding a margin to your additional break even revenue required to cover the cost of the new estimator. By including an additional 20% margin to your break even revenue of $600k you would be looking for a new project totalling $750k. The $750k includes a 20% margin of $150k. By adding margin to your breakeven calculation you will not only increase your gross profit percentage you will increase your net profit and the underlying quality of your earnings (NP%).
The example we used above is just one scenario where you can measure the impact of overhead spending. There are plenty of other areas of spending you can consider when you’re looking to grow. You may want to spend more money on marketing to generate more leads. You might want to put on an admin person to help keep on top of paperwork in the business.
We’ve made it easy for you to quickly measure the impact of spending in your business. Download our Overhead Bloat Calculator and watch the video from our recent webinar to learn more tactics on making better decisions.
Whilst the Overhead Bloat Calculator is a great tool to quickly see the impact of specific spending, to get a full view of where you’re heading financially you need to put a budget in place.
When we say budget, we mean a month-by-month view of all your known income and expenses coming up over the next 12 months, with a forecast of when new projects and related expenses are going to land. Once you have a budget you can then update it each month with your actual performance and drill down on areas that were different to your budgeted figure.
One of the most powerful things a budget will do is allow you to see into the future and guide your decision-making. You will be able to see where you may have cashflow issues due to the timing of projects as well as being able to set clear targets for how many new projects you’ll need and when you need them to land to hit your profit targets. And of course, you can add in additional roles into your overhead wages to see how this will impact your profit.
Visit our Budgeting for Builders or Budgeting for Plumbers page to download our budget tool and watch a video on best practice approach to budgeting.
Our CFO Advisory team work with business owners every day to help them achieve the profit results they’re after. If you need a hand working out how to grow your business and get some more mental clarity in the process, get in touch today for a free consultation.
