Overhead

How overhead works in a contractor’s pricing

Overhead is what it costs to keep the business open whether or not a particular job is running: insurance, vehicles, the office, software, accounting, advertising, licenses and the time spent estimating and managing. None of it shows up as a line on one job, so it has to be spread across all of them.

The usual way to spread it is a rate. Total your overhead for a year, estimate how much work you’ll do, and divide. The result is either a percentage added to each job’s direct costs or an amount added to each billable labor hour. Profit goes on top of that.

When the year goes as planned, the overhead built into each price adds up to what you actually spent. When you do less work than expected, each job still carries the same rate, so some overhead goes unrecovered and comes straight out of profit. That’s why a slow season can turn a profitable year into a loss even when every job made a gross profit.

Overhead is different from labor burden, the payroll taxes, workers’ compensation and benefits tied to each employee’s wages. Burden belongs in your labor rate. Keeping the two separate stops you counting the same cost twice.

Types of overhead

Company overhead covers the business as a whole. Job overhead, often called general conditions on commercial work, covers costs that belong to one project but aren’t part of any one trade, such as site supervision or a dumpster. Job overhead is a direct cost of that job, not part of your overhead rate.

Some costs can go either way. Decide where each one belongs, write it down and stay consistent, so job costs and overhead never overlap.

Why overhead matters

For contractors

Overhead is the cost most often left out of a price, because no single job reminds you of it. A business can show a healthy gross profit on every job and still lose money if the markup doesn’t cover the truck, the insurance and the owner’s time. Growth makes it more pressing: a new hire, a second truck or a bigger shop raises overhead before it raises revenue.

For clients

Clients sometimes add up labor and materials and wonder why the price is higher. The difference pays for the things that make a contractor safe to hire: insurance, licensing, vehicles, tools, warranty visits and someone answering the phone. A bid that leaves overhead out isn’t a bargain; it’s a business that may not be around to honor its warranty.

How to calculate and recover your overhead

1. Pull the last 12 months of expenses from your bookkeeping.
2. Mark each one as a direct job cost or overhead, using the same rules every time.
3. Adjust for the coming year: insurance renewals, a new vehicle, a new hire, software you’ve added.
4. Include a fair salary for your own management time, even if you pay yourself from profit.
5. Estimate next year’s direct costs, or your crew’s billable hours.
6. Divide annual overhead by that figure to get your overhead rate, as a percentage of direct cost or an amount per billable hour.
7. Add the rate to every estimate before profit, and check each quarter whether the overhead you’ve recovered matches what you’ve spent.

If the quarterly check shows you falling behind, either volume is lower than planned or overhead has grown. Both are easier to fix in March than in December.

Overhead example with numbers

Say a small remodeling company adds up its overhead for the year:

The company expects $400,000 in direct costs next year, so its overhead rate is $80,000 ÷ $400,000 = 20% of direct cost. Measured by hours instead, three field workers at 1,600 billable hours each give 4,800 hours, and $80,000 ÷ 4,800 = $16.67 per billable hour.

On a job with $20,000 in direct costs, overhead adds $4,000, so the break-even price is $24,000. A 10% profit markup on that brings the price to $26,400. The total markup on direct cost is $6,400 ÷ $20,000 = 32%, and the gross margin is $6,400 ÷ $26,400 = 24.2%.

Now say the year is slow and direct costs come in at $320,000. At 20%, the jobs recover $64,000 of overhead, leaving $16,000 unrecovered. That $16,000 comes out of the profit the company thought it was earning.

Common overhead mistakes

• Leaving your own management time out because you don’t pay yourself a salary.
• Counting a cost as both a job cost and overhead, such as a trailer charged to jobs and also listed in vehicle costs.
• Using last year’s overhead after adding a truck, a hire or a bigger insurance policy.
• Working out the rate on direct cost but applying it to the selling price, or the other way around.
• Forgetting annual and irregular bills: insurance renewals, license fees, equipment that wears out.
• Dropping overhead from a bid to win the job, then doing it again on the next one.
• Not checking recovery during the year, so a shortfall only shows up at tax time.

Overhead isn’t a number you set once. Recalculate it every year and whenever the business changes shape.