There are so many topics that could be written about in our industry, and have been. Yet, there seems to be a select few that continually pop up, but never seem to be understood to the point of being resolved. The one I would like to attempt is Overhead and Profit. Why has a seemingly simple phrase -“O&P” – brought so much frustration to the contractor and to an industry at large?
Let me assure everyone, it really is not confusing, it has just been made that way for several reasons. Most of them are not even worth the time to go into any detail. My goal, instead, is to break down and simplify what you need to know and ultimately help you determine the best way to use the information to know your costs, your pricing, and potentially change how our industry understands this subject.
Before I start, I will not be sharing specific percentages or financial numbers; they will only be made up examples that are only for educational purposes. The formulas are real; simply take those, enter your own numbers.
What You Don’t Know CAN Hurt You
I have worked in this industry most of my life, starting at a young age with my dad. As I worked my way up and with different companies, I found the term “O&P” popping into conversations regularly. It wasn’t until I came back to my dad’s company as an estimator that I developed an opinion about it. I had not seen an income statement or knew what that was. I was not privy to the costs of doing the work and then what it cost to run a company prior to taking this position. I am convinced now that I was the worst estimator then.
It did not take long to understand job costs once I was able to get the job cost reports from our accounting software. When we went over budget though, at first, I didn’t think it was my fault. I thought it was the carpenter or sub-contractor going over budget. What I did not realize was I didn’t make a very good budget from the start.
My perception of making money was that I had to cover the cost with the line items of my estimate and then the “O&P” was the money that the company made. When my dad found out about this perception, he was not happy. I still remember the argument about it. I falsely accused him of being too greedy.
There are estimators today that probably think the way I did. There are certainly those of you who are owners or managers that know a little or a lot better, and are shaking your heads in disgust. He likely contemplated firing and disowning me before finally showing me the income statement. He showed me the additional costs of overhead that I never really looked at. He also showed me the money that had to be made on top of all the costs that were needed to reinvest into assets or updating things we already had. Then, after all of that, the company must make a profit.
This was a valuable and eye-opening lesson that “O&P” did not give me the full margin our company needed to be successful. This information did help me know the percentage I needed; it did not answer the “how” we make this work.
It wasn’t until a man by the name of Larry Taylor from Anchorage, Alaska, one of the owners of Taylored Restoration, came to our office to critique our company and its processes. It was my turn to explain my portion of the process of doing estimating, budgeting, and project management. I explained that I take a percentage off the estimate to give to my guys or my subs to get the work done.
He asked, “How do you know that the percentage you take off is actually in the estimate and how do you know that the remainder is enough for your guys or subs to do the work?”
I told him the percentage I was using was pretty common in the industry and that I was a pretty good estimator that put everything in my estimate. He actually asked the question two more times, and I obviously didn’t really know the answer. It was very embarrassing in front of many of my peers.
After the presentation was done and I got him alone, I asked him to please teach me what he meant with his questions because I definitely needed to know, and I didn’t want to be embarrassed again. He really took me under his wing. He explained that the estimating system has line items for the costs of materials and labor that it will take to do the job, but he also showed me that if we took out the actual cost of these tasks, there may not be that percentage I needed, and in some cases it was more than what I needed.
I asked him how am I supposed to figure that out without having to tediously go through every component of every line item? He told me that it starts with making sure my pricing for the labor has enough labor overhead, because that, plus my “O&P” would give me the percentage or “margin” needed for my goal. It also requires that I put in everything to my estimate that it takes to do the work. I told him I felt pretty confident I was, but after doing reviews of my estimates, I realized I was more of an order taker than a true estimator figuring out a takeoff that would be more appropriate to get the work done.
While making sure everything is in your estimate is important, we will be focusing on the labor overhead and correct pricing, because even if you get everything in your estimate to do the work, if it is not priced correctly, we go back to Larry’s question, “How do you know that the percentage you take off is actually in the estimate, and how do you know that the remainder is enough for your guys or subs to do the work?”
The REAL Equation
To make sure we have the right amount to add to our labor, and not just rely on “O&P”, we need to know what the total general overhead and the total net profit of the company are in relation to the total sales/revenue.
To make this simple, we can use pennies and again, I want to stress, any numbers or percentages used are for informational/educational purposes only and not intended to be used.
If our total sales/revenue for the year of our pretend company is 100 pennies or $1, and our total overhead (administrative people, lease on the building, insurance, phone bill, etc.) comes out to $0.25, that is 25%. If our net profit needs to be $0.05, then that is 5%. Add those two together and we need a 30% budgeted margin. So, after any cost of doing the work of the job, we have to have an additional 30%. Now we must figure out how to add this to our labor rate. Because “O&P” gives us part of the percentage we need to keep that in mind, but it doesn’t give us necessarily what we think. It is probably better to call “O&P” by a different name because the intended name of Overhead & Profit is not what it is. I will explain. “O&P” is a markup of the line items. The margin we need would be what that percentage is of the total of the estimate. They are two different percentages. For example, if I have $1,000 in total of my line items and add 20%, that gives another $200 and a total of $1,200. Now, if I take that $200 as a percentage of $1,200 it only gives me a 16.67%. Why did this happen? The “O&P” is the percentage of the cost, but the margin is percentage of the total.
Going back to the percentage we came up with that was the total of our overhead and net profit for our pretend company of 30%. If our top tradesperson for our pretend company is making a $20 per hour wage and has $7 per hour labor burden (payroll taxes and fringe benefits), we get a total cost of $27. To apply our margin of 30% as a markup we would use this formula:
Markup = [margin / (1 – margin) x 100
[.30 / (1 – .30) x 100 = 43% markup
$27 x 43% = $11.61
A portion of this will come from our “O&P” markup.
$38.61 / 1.20 (the 20% from “O&P”) = $32.18 (this took off $6.43)
We must charge $32.18 per hour for our retail labor rate in our estimate to make a 30% margin.
$27 is our budget and $11.61 is a 30% margin we should keep to sustain our business.
Soon there will be an educational video that I have done that will be available through the Restoration Industry Association for its members that will show how to apply this as part of creating your own price list in Xactimate. It will actually work for any system.
In the meantime, all you will have to do is substitute the 30% margin in the above scenario with what your actual financial information is for your company and replace the tradespersons wage and labor burden with what you actually pay. You don’t even have to apply “O&P”, you could put the entire amount of markup in your labor overhead instead.
From our pretend scenario that looks like charging $38.61 with 0% “O&P”. OR, you could put the entire percentage for “O&P” as a markup. From our pretend scenario that looks like charging $27 but with 43% “O&P”.
Again, so we are all on the same page, “O&P” is not actual general overhead and net profit. It is just a markup with a poor name. Who knows where it came from or why it is called that but now you know how to determine the correct amount and how to apply it, no matter what it is called.