CWB May 2001

Paying the Bills... and Then Some

The fourth of five parts for shop owners disappointed with their business's profits.

Anthony Noel

"Did you remember to pay the utility?"

- Green Day, from "Warning"

You have been in business for a few years, working yourself silly, yet at the end of the work week or the end of the month or the end of a job, you find yourself wondering why you are not making more money. Judging by the response to this series so far, you are far from alone.

We started back in February with a simple premise: That if you are not making money (or the money you want to be making), it is nobody's fault but your own. In the months since, we have tackled homework assignments, following a systematic approach to making the business of custom woodworking as financially rewarding as possible.

To quickly review:

We began with an assignment to keep careful track of the direct labor on each job in your shop, listing specific tasks and recording the time spent on each task as it was completed.

For March, the assignment was to begin differentiating between direct and indirect labor, and to begin tracking the latter just as comprehensively as we have been the former.

Last month, your objective was to assemble all your overhead costs - things such as rent, utilities, vehicle and equipment maintenance, tool sharpening, professional fees, taxes and other ongoing costs that come with being in business.

So here it is May, and we're closing in on it ("it" being the information you need to apply to your pricing formula if you want to make money). However, before we look more closely at that formula and how to distribute your overhead costs across your year, I must sound two refrains familiar to regular readers of this column:

  1. If you want your business to be profitable, you can only achieve that by analyzing your numbers, and
  2. You must constantly review and update those numbers - be they overhead expenses or direct and indirect labor costs - if you want to achieve long-term profitability.

If you did last month's homework, you now have a list of your overhead expenses for the past year. And if, since the beginning of this series, you have consistently kept track of the time your business spends on direct versus indirect labor, you have about three months' worth of history (one quarter's worth) of that information. This means that you can reasonably project how much time your business expends in the shop on tasks directly related to specific jobs, which is just what we need to know in order to equitably distribute overhead costs among those jobs.

It's really very easy. Just as, in an example from last month's installment, we distributed the cost of indirect labor across the jobs we do in a given year, we are now going to do the same with overhead costs. Some of you may be wondering, "Well, couldn't I just lump indirect labor into the overhead amount?" The answer is a qualified "yes."

I have no problem with tacking indirect labor costs onto the total overhead. But I believe it is important to keep separate track of it. I think it is critically important to consistently track the time you expend on indirect labor tasks, and I strongly recommend developing a worksheet listing such tasks, just as you have (hopefully, by now) developed one for direct, job-specific labor. The reason (and this is of particular importance to growing companies and larger companies), is that indirect labor costs can quickly price you out of your market if you are not keeping an eye on them.

Though I don't want to digress too far from the topic at hand, just know that indirect labor costs have a tendency to grow quickly. This is especially true in growing companies, where administrative tasks increase exponentially. That is fine as long as you are covering these increased costs. But you can't do that if you are not keeping track of them.

So sure, throw your indirect labor costs into your overhead. But avoid the temptation to assign some sort of percentage to them or to recoup them based on the work currently in the shop, or through some other equally lazy - and therefore ultimately inaccurate - means. Break them out separately, and keep track of them religiously.

Assuming you now have a list of your overhead items, you need to figure out how many direct labor hours per year to distribute them across. This should be an easy task, since you have those aforementioned three months of history.

Let's say, using the example of a one-man shop, that you worked 410 hours on specific tasks for specific jobs (direct labor). And let's say that you have come up with an annual overhead figure based on a list that looks something like what is shown in the box to the left.

To be sure that we are making enough to pay ourselves for our direct labor and to cover the expenses listed as overhead, we need to spread the total overhead amount across the total number of hours we reasonably expect to work for the year on specific jobs, because that's where our money comes from. To get our annual figure, we multiply our theoretical direct labor total for one quarter by four. In our example, this is 410 hours times four quarters for the year, and we get 1,640 hours. When we divide that into our overhead total for the year ($39, 496 in our sample below), we come up with $24.08.

OVERHEAD CALCULATION
Rent

Utilities (phone, electric, trash removal etc.)

Professional fees

Indirect labor

Taxes (Social Security, Medicare)

Employee benefits

Bank fees

Tool sharpening

Small tool purchases

Ongoing shop supplies

Machine/equipment maintenance

Vehical expenses

TOTAL OVERHEAD
$6,000

3,384

800

16,362

3,825

4,800

125

750

1,000

500

750

1,200

$39,496

Let's say you are a one-man shop owner, wanting to make $50,000 per year. Of that, $16,362 will come from indirect labor (as shown in our overhead list). The other $33,638 must come from actual jobs. And since you are working 1,640 hours per year on those jobs, a little more division shows that you must charge a base hourly rate of $20.50. If you added that to the $24.08 required to recoup overhead costs, it yields an effective hourly rate of $44.58.

Now, I must jump in here with a very loud note of caution: The hourly rate we have come up with in our example is very close to $45. Time and again, I get e-mails from people asking, "What's a good average hourly rate to charge." They want a round number to compare their own rates with, to see if they might be "too high" or "too low." And time and again, I explain that knowing some "average" is useless.

I hope you will heed this warning. Don't just pick a number and hope it works. You have invested too much of your time and money to do that, and that very fact - that your time and money is completely different from anyone else's - is why it's so crucial to forget about averages and do your homework.

As you have probably already guessed, that's your homework for this month: To pull all the elements we have already discussed together and establish your actual costs and an effectively hourly rate based on those numbers. Then you will be ready for next month's final installment: Taking a profit.

 

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