Like many small contractors, you probably want your business
to grow and produce more profit. But growth entails risks,
including the possibility that hiring more managers or office
people could increase overhead to such an extent that profit
declines. Buying expensive equipment or moving the office from
your house into rented space could have the same effect.
Still, if you want more profit, your company will most likely
have to grow. The smart thing to do is to minimize your risk by
going into it with a plan.
A Question of Volume
The part of the plan I want to talk about is not as sexy as the
part most contractors want to think about — who they're
going to hire, where their office will be, or what new
equipment they are going to buy. I want to talk about the
financial part — namely, determining how much volume your
company must do to support the added overhead.
One way to evaluate whether to add overhead is by creating a
break-even analysis. Although this may sound complex, it can be
boiled down to a simple formula, which I'll discuss later.
First, though, you need to understand the theory behind the
Job costs vary according to the size of the job, but overhead
is fixed. If you're going to increase overhead, you need to
increase your volume of work; otherwise, your net profit will
decline. The question is this: By how much does volume need to
Let's look at the numbers. If a $100,000 job costs $65,000 to
produce, you will have a $35,000 gross profit. That $35,000 can
be used to pay the company's overhead costs as well as the
owner's profit. Reflected as a percentage, this gross margin is
35 percent of income. If the company completes two of these
jobs, you would expect a gross profit of $70,000 (35 percent of
Once you determine your gross margin per job and can hit that
number consistently (or at least on average), the rest is easy.
It's simply a matter of taking the gross-margin number and
working backward to the volume that will cover overhead and
leave you with the desired amount of net profit. Here's the
overhead ÷ gross margin = volume
Let's say, for example, that your margin is 35 percent and you
want to rent an office that will add $21,000 a year to
overhead. You would need to increase your yearly volume by
$60,000 ($21,000 ÷ 35 percent = $60,000). If you rent
that office and do not increase volume by $60,000, your net
profit will fall.
Need for accurate statements. Knowing
this, you can create what-if scenarios that show what the
financial consequences would be for various changes to volume,
overhead, or margin. This works only if you have accurate
financial statements and understand what's in them (see
"Looking Beyond the Bottom Line," Business,
The statements must clearly distinguish between direct and
overhead costs. Direct costs are tied directly to the job and
are subtracted from income to determine gross profit. Overhead
costs are the costs to run the company and are subtracted from
gross profit to determine net profit.
The financial statement should include a subtotal for gross
profit and show the amounts in percentages as well as in
dollars. For a sole proprietor, the financial statement would
look something like the table on the previous page (Table 1).
Notice that in the example the contractor has a net profit of
$70,000, which represents 14 percent of total income.
The next step in performing a break-even analysis is to restate
the financial statement as a break-even statement.
There is no net profit in a break-even statement. Instead, you
take what would have been net profit, call it "set-aside
profit," and move it into the section for overhead. The
financial statement below (Table 2) shows how this would
Why it matters. Moving net profit
into the overhead section may seem strange, but there are a
couple of reasons for doing so.
First, it makes it possible to perform the break-even
calculation with simple math. Second, it forces you to plan. If
you are a sole proprietor, you probably don't draw a regular
paycheck; instead, you pay yourself with profit. If there isn't
any, you don't get paid.
So, in this context, "breaking even" means paying everything
— direct expenses plus overhead and the owner. Far too
many contractors think "breaking even" means covering their job
(direct) expenses; they fail to adequately account for overhead
How much? The amount of set-aside
profit is up to you; it could be an actual salary or what it
would cost to hire someone else to do your job. Whichever
approach you choose, that amount needs to be left over after
the direct expenses and other overhead items are paid. Once you
have transferred net profit into the overhead section, you can
determine the break-even volume for your company. The formula
total overhead ÷ gross margin
= volume to break even
This should look familiar — it's the same formula as the
one described earlier, except this time we're looking at the
break-even volume for the entire company, not just the volume
needed to support a particular overhead cost. For the company
shown in the tables on the previous pages, the calculation
would be $175,000 ÷ 35 percent = $500,000.
What If Your Margin Slips?
But what happens if your gross margin falls? If it were to fall
from 35 percent to, say, 30 percent, your break-even point
would no longer be valid. If the regular items in overhead stay
the same, you would need to produce more work at the new lower
margin to achieve your set-aside profit goal. In that case, the
calculation would be $175,000 ÷ 30 percent = $583,333.
The financial statement would then look like the table below
(Table 3). The direct-expense amounts are not shown because
they don't really matter here. All we need to know is that the
gross margin is now 30 percent.
If your gross margin fell to 30 percent and you were not able
to raise your volume, there would be $150,000 available —
instead of $175,000 — to cover total overhead. Where
would that $25,000 difference come from? Since overhead costs
are fixed, it would come out of the set-aside profit (your
pay). The financial statement for this situation is at left
(Table 4). The reverse is also true, of course. If you increase
the gross margin on a given volume of work and overhead doesn't
change, then set-aside profit (or net profit) goes up. Slashing
overhead has the same effect.
Hiring Another Manager
The break-even analysis can also be useful when you're trying
to decide whether to bring on an additional project manager. If
you, as an owner, are ready to take on a project manager to
help you grow, then you need to be sure you can cover both his
and your own salary.
What would it cost to replace yourself? If you had a profit of
$70,000 and hired a project manager for $70,000 (including
comp, insurance, and so on), there would be nothing left for
you. For this to work, the project manager would have to help
you increase volume to the point where he pays for
How much additional volume would that take? If you continued to
meet the 35 percent gross margin, you would need to increase
your volume by $200,000 (70,000 ÷ 35 percent). But
volume doesn't usually jump that dramatically. So you would
need to decide for how long you'd be willing to cover the cost
of the project manager. Once volume grew by $200,000, you would
be breaking even on the new project manager.
But for a businessperson, it's not enough to break even; you
want the project manager to help you boost volume by more than
$200,000 — without reducing gross margin.
Playing "What If"
Here are other ways you can play with the numbers shown in the
What if I hire an office assistant who costs $25,000 per year?
•• At a 35 percent margin, my volume must increase by
$71,428 (25,000 ÷ 35 percent).
• At a 30 percent margin, it must increase by $83,333
(25,000 ÷ 30 percent).
What if I want to give myself a raise, so I increase my goal
for set-aside profit from $70,000 to $100,000?
• At a 35 percent margin, my volume must increase by
$85,714 (30,000 ÷ 35 percent).
• At a 30 percent margin, it must increase by $100,000
(30,000 ÷ 30 percent).
I've seen contractors really struggle with these examples. At
first they're skeptical, but as they work through the numbers
they begin to understand the role of gross profit in their
business and realize that construction — at least the
financial part — can indeed be boiled down to a numbers
game. Once they understand that, they can ask the important
question: What volume makes sense for me and my company?Leslie Shinerof Mill Valley, Calif., has worked as a
financial and management consultant for more than 20