The Garrison Report #2007-1

Eliminate Your Corporate Overhead

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The title was designed to catch your attention, but the discussion is probably not about what you expect.

Obviously, we can't just wave a magic wand and make corporate overhead expenses disappear. However, we can manage them better. It's not about eliminating the work or the cost; it's about properly assigning the costs. In other words, every possible corporate expense should be charged to a specific project if at all possible. Of course, the company picnic, the corporate office, or the time the president spends working on strategic planning are legitimate corporate overhead expenses and must be allocated across all projects based on some equitable basis. But in reality, corporate expenses would be better understood if charged to the specific job where the cost was incurred. For example, if the contractor's president must meet with the project owner, then that portion of the president's compensation should be charged to the project instead of corporate overhead.

Why is this important -- even essential? While this approach will provide a more accurate reflection of where overhead costs are spent, more important, it will allow the contractor to determine what projects actually make a profit.

The Pareto Principle, or the 80/20 Rule, explains why this important. When a contractor's financial records are accurately analyzed, it is usually found that approximately 20 percent of a contractor's projects generate 80 percent of its profits. The next 60 percent of its projects create 40 percent of the contractor's profits. This means the last 20 percent of the contractor's projects actually lose 20 percent. However, when the author makes this statement to audiences, he is often challenged because contractors argue that all their job cost reports indicate every project made money. This is often true because the project cost reports don't accurately reflect overhead expenses. It doesn't matter whether the general contractor simply adds a fee to the project that covers corporate overhead and profits or a subcontractor adds a specific overhead figure plus a profit fee.

First, many cost reports don't make any allocation for corporate overhead expenses. Therefore, the profit reported is merely the project's gross profit, not net profit. Other contractors do subtract corporate overhead to determine a net income figure, but that amount is usually based on a uniformly applied overhead. Why is this wrong? Simply stated, it's wrong because corporate overhead is not generated equally on all projects, so applying overhead equally results in false conclusions.

A classic response the author often receives is, "If the project makes any profit, it's contributing to overhead." Not true. If you are spending more on corporate overhead on that project than you earned, then you are losing money; losing money on a project does not contribute to overhead.

This conventional wisdom is based on a false premise that overhead is a fixed expense. In other words, since the corporate president, the CFO, the estimating department, and other costs will be incurred anyway, what difference does it make which project is charged for those expenses? Unfortunately, this thinking results into major mistakes.

First, when you allocate corporate overhead directly to projects, you find out that not all overhead costs are necessary. In this approach it is usually found that certain overhead costs are a result of particular projects. If the contractor didn't perform these projects, these costs wouldn't be incurred. In essence, eliminating the particular type of project would eliminate the overhead expense. Or if the contractor wants to perform that type of project, those projects should be charged the full cost of that service. No contractor would consider charging all its projects so much a square foot for, say, electrical work instead of itemizing the actual costs. So why do we do it with expenses that are incurred in the office instead of on the job site?

If you take these costs and spread them out over all your projects, you create two bad situations. First, by spreading out a cost incurred on only a few projects over all your projects, you undercharge the clients who requested the service. No wonder you get these projects! You aren't including all the costs. What's worse is you are adding costs to your other projects that have not incurred these costs. This can result in your losing a job because your costs are too high. Think about how ridiculous this approach is. We count bricks-and-mortar items down to the penny; then we take a swing at the overhead.

For example, let's assume you have to prepare ten estimates to kick off a particular project for a client. Why should the estimating costs for these ten estimates be spread over all projects? In other words, projects that required only one estimate are being charged for estimating costs they didn't incur. If you charged the project that required the ten estimates for all those estimates, the project would probably have lost money. Should you really chase that type of project, especially if your average number of estimates for other projects is less?

Another common response is also nuts: "Estimates are a cost of doing business!" Who came up with that theory? Estimates are a cost of building a project. It's part of the planning process for a project. So why should owners who require only one estimate be charged for several estimates because some other owners want to abuse the process? Oh, you say that you bid work competitively, therefore bids are just part of the process. The author still disagrees.

Let's assume you commonly bid work to the local school board. You are awarded one out of ten bids you submit. The author says you should charge all of those bids to the school board project because that's what it took to get the work. "Not fair," you say. "If you do that, you will lose money on the school project." That's the author's point exactly! However, when you take the burden of these ten estimates off your other projects, they suddenly look a lot healthier.

The point of this exercise is it allows the contractor to analyze its projects to determine which projects actually produce a net profit. With this information, the contractor can better determine which projects it should chase and which it should avoid. In a competitive marketplace, can you really afford to charge a client for charges that he didn't incur?

Again, if you are forced to chase a particular type of project, it would make more sense to at least place the correct costs on that project. The author understands that contractors must use an estimated overhead figure to bid projects. No problem, he agrees. However, if you start to charge overhead expenses accurately, you will begin to develop a clearer understanding of your overhead costs by types of projects and even clients. For example, if a general contractor self performs its own concrete work, it might find that a poured-in-place concrete project typically has higher corporate overhead expenses than subbed-out steel-framed building. If that were the case, would it make sense to charge both types of projects the same overhead cost?

Another trap occurs when corporate management jumps in to bail out a bad project. When a project goes south, everyone chips in to save the project. Unfortunately, too often this extra overhead expense exceeds the project savings. Yet because the project ends up with a net profit, everyone cheers. While the overhead effort may have saved dollars, if those costs aren't applied to the project, it appears the project was profitable. Worse, because corporate management's time was redirected to this project, how many other projects suffered? How many opportunities were lost due to a lack of time?

Every contractor will have a bad project from time to time; it's the nature of the business. These problems occur for a multitude of reasons, such as poor estimates, mistakes in construction, or the selection of a poor subcontractor. These issues should be dealt with in a different manner, but the process of charging overhead costs to projects helps identify trends. In essence, it's about learning which clients and types of projects are most profitable so the company can focus on them. By placing the correct corporate overhead on projects you will make your company more competitive.

Even if you don't believe this is a worthwhile effort for your company, you should consider the client. Your job is to protect the client; that means you have an obligation to not charge the client for work that was not performed on his or her project. This includes corporate overhead. In the end this is the most equitable approach for all stakeholders.

 

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