Jim Huston |
The primary test of a cost estimating system is whether it calculates your costs – all of your costs – accurately. That may seem painfully obvious but many estimating systems violate this principle. Secondly, cost estimating is a science. As such, all of the formulas and mathematical assumptions in a cost estimating system must be open to verification by independent third parties. Four of the five most commonly used estimating systems within the green industry use percentages (one, two or four of them) multiplied by the direct costs in a job to measure, allocate, recover and control (MARC) general and administrative (G&A) overhead costs. And since G&A overhead costs usually run 25 percent of a company’s sales, these costs are significant and need to be calculated correctly, and accurately included in one’s pricing for projects and/or services. Unfortunately, all G&A overhead percentage-based estimating systems fail the primary test for an estimating system. They all have serious mathematical flaws when it comes to estimating G&A overhead costs for an installation project or green industry service. Their faulty arithmetic needs to be exposed using the methods of science.
An estimating system needs to calculate the following general categories of costs accurately: materials, labor hours and labor dollars, labor burden, equipment, subcontractor and G&A overhead. It also needs to calculate a reasonable amount of net profit margin to add to the project or service. It is through job costing that you collect data, as the project or service is completed, and compare the budgeted amounts for each category to the actual amounts used. If your estimating is accurate, the difference between the two (the variance) will be zero. It is this data collection process that tells you if your estimating system is accurate, your production is on target, and/or if you need to adjust your estimating production rates for future bidding.
Here is how three of the four percentage based systems calculate prices for two different jobs. For ease of arithmetic, we’ll stipulate that our entire field workforce costs $10,000 (with labor burden) per month and our total G&A overhead costs are also $10,000 per month. - Materials factoring: You multiply the materials in a project by a simple factor.
Using a materials factor of 3.0, your price would be $30,000. The GPM is -$90,000…Oops!
Using a materials factor of 3.0, your price would be $300,000. The GPM is $180,000… Whoopee!! See the problem? - SORS (the single overhead recovery system): You multiply your total direct costs in a bid by a factor.
Using a SORS factor of 1.3, your price would be $156,000 and the GPM $36,000 for both jobs. Assuming a 10% net profit margin or $15,600, that leaves $20,400 for G&A overhead for both jobs. But job A requires ten months of G&A overhead ($100,000) verses one month of G&A overhead ($10,000) for job B. The arithmetic in the SORS method is faulty. - DORS (the dual overhead recovery system): This method applies two different markups to direct costs—one to labor costs and one to material costs. We’ll skip this method as it makes the same mistakes as in the MORS method.
- MORS (the multiple overhead recovery system): With the MORS method, you add 5% for G&A overhead to subcontractor costs, 10% to materials and 25% to equipment costs. The labor markup is calculated from the annual budget and the other three percentages. It usually ranges between 35 to 95%. We’ll use 55% but any percentage within this range will illustrate the problem.
Total price for job A is $196,350. Total G&A overhead on the job is $58,500. MORS understates the G&A overhead by over $41,000.
Total price for job A is $151,580. Total G&A overhead on the job is $18,000. MORS overstates the G&A overhead by over $8,000.
I then added, as shown above, that all percentage-based G&A overhead estimating systems have serious mathematical errors embedded in their arithmetic. Materials factoring, SORS, DORS and MORS can get you into serious trouble. Furthermore, the three markup percentages used in MORS by just about all users to mark up direct costs to recover G&A overhead costs (the 5% on subcontractors, the 10 percent on materials and the 25 percent on equipment) have never been scientifically verified by independent third parties. The reason is simple. They cannot be verified. I guess if you candy-coat materials factoring, SORS, DORS and MORS; you get SMORS. And while candy may taste good, a steady diet of it can harm your physical health…just like factoring used in your estimating system can harm your financial health.
JIM HUSTON runs J.R. Huston Consulting, a green industry consulting firm. See www.jrhuston.biz; mail jhuston@giemedia.com. |