Business

Calculating the Overhead Recovery Rate Can Make or Break a Business

Failing to recover the full cost of overhead in estimating or pricing likely will make a business, product or job unprofitable when the final numbers are applied.
By Stuart Groo
April 30, 2018
Topics
Business

When pricing or bidding a job, it is necessary to figure that for every dollar spent on the cost of goods sold, an additional percentage must be added to recover the overhead or fixed operating expenses that cannot be included in the bid. This ratio is derived from the proper allocation of overhead (indirect expenses) and the cost of goods (direct expenses).

Overhead represents fixed operational expenses not directly billable to a job (e.g., rent, utilities, administrative salaries and liability insurance). Failing to recover the full cost of overhead in estimating or pricing likely will make a business, product or job unprofitable when the final numbers are applied.

Knowing what expenses constitute cost of goods and what expenses constitute overhead is critical to calculating the overhead recovery rate. A general rule of thumb to distinguish between direct costs and overhead is whether the cost is directly attributable to producing revenue, can be charged to the job or will increase as more work is obtained.

Usually, items such as direct labor and materials fit these criteria. If an item does not meet these criteria, then it likely needs to be treated as overhead.

Basics and Best Practices

Basically, for every dollar spent on the cost of goods sold, an additional dollar amount (determined by the overhead recovery rate) must be added to recover the overhead. This provides a consistent application to all jobs.

The overhead recovery rate may be based on actual historical financial data or a projected budget. Both calculations should be made for comparative purposes. Given the importance of the overhead recovery rate, revenue and all costs (whether directly or indirectly related) should be continually monitored.

Remember that changes in the amount of the cost of goods will impact the overhead recovery rate. Even though overhead expenses are primarily fixed, and therefore revenue increases or decreases will have little direct impact on them, a downward trend in sales will raise the overhead recovery rate needed because there will be less cost of goods to spread them over.

It is crucial that overhead be monitored not only as a percentage factor, but also in terms of dollars. An overhead recovery rate expressed in percentage terms is reliable only if the company achieves the targeted revenue and maintains the associated direct costs at the projected level on which the factor is based.

Additionally, become intimate with all aspects of overhead—not only the estimated annual percentage factor, but also what the annual overhead dollar amount breaks down to on a weekly, monthly, quarterly and semiannual basis. The capture or recovery rate of overhead should be tracked on an ongoing basis. An overhead recovery rate is never fixed or constant; it is continually changing.

The Formula for Success

Dividing the overhead by the cost of goods will yield the percentage (overhead recovery rate) needed to apply to direct costs in order to cover fixed expenses or overhead. If overhead costs are $245,000 and the cost of goods are $529,000, then the overhead recovery rate would be 47 percent ($245,000 / $529,000 = .4631 or 46.31 percent).

To simplify, round up and use 1.5 as the rate to conclude the business must recover an additional 50 cents for every dollar of direct costs.

In a construction company scenario, a firm could take its billable hours for each crew and arrive at an overhead rate per hour of work. If it had two crews each with two workers billing 4,000 hours per year (2,000 per person), it could divide the overhead by 8,000 and arrive at an overhead rate of $30.71 per hour. This is what would need to be charged per manhour over and above the burdened labor rate that has already been applied.

How a company’s chart of accounts is laid out and, more specifically, how its profit and loss statement is structured, is extremely important in calculating the overhead recovery factor. How and where budget costs are allocated (cost of goods vs. overhead expense) will have an impact on a firm’s overhead and its overhead recovery factor. If, for instance, an owner/manager does some office work, some field work and some direct job supervision, it’s crucial to decide how to treat this expense. Stay consistent and know where the costs are.

Assuming that the job can be performed within the allotted labor hours and materials costs, then the profit being calculating is “true” profit. All other expenses have been accounted for. Therefore, that 15 percent profit may not be necessary. If jobs are scarce, go with a 5 percent or 8 percent profit to win the bid. However, do not start to adjust the break-even price; this is sacrosanct.

In many construction jobs, it may be best to only mark up the materials a nominal amount, such as 4 percent, rather than the full overhead. Instead, increase the overhead applied to the labor.

Materials for competitively bid jobs are going to cost everyone about the same, so it’s not feasible to mark them up as high as necessary. But, the cost of labor is unknown to competitors, so the additional overhead recovery amount will not put the company outside the range of competitive bids.

by Stuart Groo

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