How to Calculate Your Breakeven Cost Per Hour
Over the past five months we have devoted a lot of space to how to determine what the real cost of doing business (from a cash flow perspective) is for your company. We first determined the cost of replacing your equipment, which was followed by determining your largest single cost-the cost of nonbillable time. Next, we looked at markups and then profit margins for the materials and spare parts that you sell. After that, we covered the cost of company matching taxes. In the May issue, we connected all the dots together to determine what our total cost of doing business really was. Many readers, I suspect, found out just how expensive it is to run a company and how other contractors can under bid you. Most under bid for one reason and one reason only-they don't really know what their real cost of doing business is and what to charge to cover that cost while generating a reasonable profit.
If they understand the numbers, as we have reviewed them over the last few months, most would raise their rates and there would not be huge differences in pricing to the customer. This article will now take our real cost of doing business and help us determine what our breakeven cost per hour is. The breakeven rate will tell us what hourly rate we must charge to cover our basic costs of doing business-with no profit. Before we can generate a profit, all of our costs of doing business must be absorbed. The rent, utilities, cost of nonbillable time, owner's salary, insurances, etc. must be paid before a profit can be generated. There are only three things in a company that can absorb overhead costs. The markup on equipment, materials and spare parts can absorb some of the overhead. In theory, subcontracting can also absorb overhead. In reality, however, few of us sub out work and, when we do, it typically gets "passed through" with little or no markup. Therefore, whatever overhead is not absorbed by materials (and/or subcontracting) must be absorbed by our direct labor hours-it's the only thing left.
The best, or ideal, situation is for your overhead (all of it) to be absorbed by direct labor hours with none being absorbed by materials or subs. This is the best case since that gives the contractor total and complete flexibility on marking up materials. If your overhead is absorbed by labor, any profit made on materials is just that-profit. With the overhead absorbed by labor, it also allows the contractor a lot of flexibility on pricing. The bid price of a job can be dramatically increased or decreased by the amount of profit (markup) put on the materials and/or equipment. Since all your company overhead is covered by labor (which will include your desired profit before we are done) it is not necessary to markup materials at all to cover costs and generate a profit. This process, therefore, allows the contractor a lot of flexibility on bidding a job.
Now remember I said putting all the overhead costs on labor is the best situation. The reality is that few contractors can actually put their overhead on labor alone. Putting all overhead costs on labor often makes the labor rate far too high to be competitive in the marketplace, but it can be done. I have worked with three companies over the past several years that were able to put their overhead on labor and still had a very reasonable hourly rate. Guess what? They were also making a lot of money too! I will show you how to figure your breakeven rates with, and without, putting some of the overhead on materials and then you can look at your rate and determine for yourself which way you want to go.
To make things really easy to understand, let's look at ABC Company and go through the process of determining our breakeven rate. These are our assumptions:
- 1.Billable hours to the customer = 4,000 per year
2.Total material cost (equipment, materials and spare parts) per year = $200,000
3.Average markup on the above materials = 30%
4.Company does NO subcontracting
5.Total "real" overhead = $250,000
6.Average hourly rate for field tech is $18.00 per hour If our markup on materials is 30 percent that means we have $60,000 in gross profit on materials ($200,000 x 30% = $60,000). Our overhead rate per hour ($250,000 - $60,000) 4,000 billable hours = $47.50 per hour.
The breakeven rate is then the overhead rate plus the average hourly rate in the field or: = $47.50/hour overhead + $18.00 average base rate = $65.50/hour breakeven
The $65.50 is the breakeven rate when material markup is used to subsidize the rate. If all the overhead were placed on the hourly rate, the breakeven hourly rate would then be: ($250,000 / 4,000 hour) + $18.00/hour = $62.50 + $18.00 = $80.50/hour breakeven
As you can tell, allowing material and equipment markups to subsidize your hourly rate makes a big difference, about $15.00 an hour in our above example.
Before you can fill out Worksheet 8, you will have to determine what overall net pretax profit and an overall net profit you would like for your company to earn. Everyone always asks what a reasonable profit is. Well, if you look at all the studies done by all the different groups, they all show the same thing. Average net profit is 3 to 5 percent. Is that a real figure? No. Anyone earning more than 3 to 5 percent normally pulls the money out as a bonus, puts it into retirement, buys something or simply spends it in some way so they can come back to 3 to 5 percent since that is what they want to pay taxes on. As far as I'm concerned a well-managed company should generate profits as follows. If you can break even or even make a little profit in new construction, great. That is a tough market. Retrofit and remodeling work should generate a 6 to 12 percent net profit while service and repair should be the most profitable thing you do. A well-run service department should generate a 15 to 20 percent pretax net profit. If you switch to flat rate pricing, the service profit can easily grow to 25 percent.
Go ahead and select an overall net profit you would like to earn. Most pick 5, 10 or 15 percent. You will notice on Worksheet 8, the third line says "Less desired profit". At that point take the net profit you want to earn and multiply it by the total marked up material dollar figure on the first line. The resulting figure goes on the third line. The reason we are subtracting the profit on materials here is that we want to make an overall company profit. That means we need profit on our materials and our labor. Now go ahead and fill in the two worksheets and then next month we will talk about how to add profit to our breakeven hourly rate.
There are two more articles to come on calculating your hourly rate. As I stated above, next month we will talk about how to add profit to our rate. The final article will talk about how to go through the "What If" process of changing things to see how those changes will affect overall company profitability.