Understanding Costs Means Profit
Reprinted with permission from Modern Woodworking.
By Jeff Crissey
Understanding the factors that affect cost when you work on a job are critical to a healthy bottom line. While every business is different, one thing is certain: The only way to stay competitive is to keep detailed information on the time it takes to do specific tasks, material expenses and the day-to-day costs of running your business — and do it consistently. Too often, companies overlook the costs of being in business, which inevitably leads to weak profits, or worse, puts the company out of business. Knowing your costs is the best way to ensure your next job estimate will allow you room to take a profit.
Calculate shop costs
The first step to accurate estimating is nailing down shop costs. Simply put, the cost of running your business can be broken down into two categories: direct labor and overhead.
Direct labor is any task that is performed directly related to the product. For example: cutting, sanding, assembly, finishing, delivery, installation, etc. Each of these tasks is directly associated with the final product. Direct labor is also referred to as billable hours. You must have a clear idea of how long each of these steps takes to complete in order to establish a labor rate (see “Calculating a labor rate”).
Overhead is a group of expenses that includes rent/mortgage, machine financing, insurance, utilities, company vehicles, taxes and indirect labor, among others. Indirect labor is everything else done in the shop not included in direct labor: machine maintenance, blade changes, sweeping the floor, providing estimates, attending design meetings, etc. Accounting for overhead is essential to a profitable business. If you don’t factor these expenses when you bid a job, you’re likely on a sinking ship.
“That’s a place where a lot of people make mistakes,” says Ed Vickery of California Woodworking, a commercial casework shop in Oxnard, Calif. “If you don’t figure in overhead to your pricing, you’re losing a lot of money. You may not have any profit left because overhead expenses are eating it all up.”
To determine the amount of indirect labor in a week, first establish how much time you average a week on direct labor. Keep a log over a period of time to track specific tasks, the longer the better. Eight to 10 weeks should result in an adequate average.
“We have special timecards printed up for each employee,” says Vickery. “When he works on a job, he writes down the job name and fills in the amount of time it took him to complete the task under the appropriate category — fabrication, installation, cutting/machining and sanding, for example. We then tabulate that information in a spreadsheet to give us the total direct labor hours per job.”
Once you’ve developed a weekly average of direct labor hours, subtract it from the number of total hours of operation in the week. What’s left are the indirect total hours worked per week. Multiply this by 50 to determine the number of indirect labor hours per year. Then multiply by your labor rate to establish your yearly cost of indirect labor.
Lw – DLw = ILw
ILw x 50 = ILy
ILy x LR = total cost of ILy
where L = Labor hours
DL = Direct labor hours
IL = Indirect labor hours
LR = Labor rate
w = per week
y = per year
Since overhead can’t be itemized and charged directly to a client, your easiest (and fairest) way to recoup these expenses is to factor it into your pricing for actual jobs you perform by the hour.
For example, suppose a cabinetmaker’s entire overhead costs (indirect labor included) are $25,000, and that he works 1,250 hours of direct labor per year. To distribute his overhead, he divides it into his direct labor hours for a cost of $20 per hour. To that he adds his predetermined labor rate for his total labor rate.
As your business grows, so may your overhead. It’s important to monitor your costs over the course of the year and adapt your total labor rate to reflect any major changes in business costs. “It’s important to review your overhead expenses annually,” says Vickery. “Any more often than that and you’ll have less-reliable information. The bigger the window, the more accurate the information will be.”
Charge for estimates
Whether or not to charge potential customers for estimates is a hotly debated topic among custom woodworkers. If you account for the time it takes to develop an estimate and the associated legwork as indirect labor in your overhead costs, then your actual customers (the ones you’re able to charge an hourly rate) are paying for that time. In other words, every job that you do get helps toward recouping the efforts lost wooing these would-be customers.
Other companies view estimates as a service provided, and they expect to be paid for it. They generally will charge a fee for the first visit to cover the costs of travel and time they spend away from the shop — in essence, charging for this line item of indirect labor up front instead of rolling it into their overhead.
“I ask the client to sign a retainer that states that I come up with the design, drawings and estimate, and it will cost X amount,” says Sam Benbow, owner of Benbow and Associates, a custom cabinetry shop in Asheville, N.C. “It commits them, and it commits you. It also qualifies the clients. If they’re going to take your design for free and then go shop your price against Home Depot, you don’t want them anyway. By getting them to sign a retainer, they’re committed — they’ve already said their first ‘Yes’ toward signing a job contract.”
Determine best method
There are a number of methods woodworking businesses use to estimate and price jobs, and like anything else, some are better than others. Experience is the best way to determine which one works best for your company.
Here are some details about each of the more common methods:
Time and materials - Those who successfully use the time and materials method use a labor rate that includes direct labor and overhead, along with materials, plus a markup, usually between 30 and 50 percent to obtain a profit. This is a commonly practiced and generally accepted estimating method that works well with most cabinet shops, regardless of size.
“When I use the time and materials method, I try to price it as close as I can,” says Benbow. “I cost the materials I’m going to use, then add in the cost of freight, delivery or pickup and add a markup to it to cover my overhead. Your markup is what makes you a profit with that system.”
Component parts pricing is used if you want to establish standard costs for specific components. For example, a 30-inch base cabinet will cost X amount, and each drawer or cabinet door will cost X amount.
Linear pricing - Linear pricing, or pricing a certain amount per foot material, is best used by trim work and architectural millwork companies, because their jobs are more easily calculated on a lineal foot basis.
Cabinet shops that price with this method usually have a standard cost for upper and lower cabinets, then charge extra for additional drawers, pull-out bins, etc. One problem with cabinet shops using this method is the number of variables that are available to the customer with different door styles, drawer boxes, wood species, etc. It does work for cabinet shops who keep their product offering options low.
“I used to estimate with linear pricing,” says Bruce Spitz, president and owner of Classic Millwork, El Paso, Texas. “I developed a retail lineal foot price for three or four different types of cabinets and countertops and basically used that to cover most of what we were doing. But I wanted to break out the material and labor requirements for building the cabinets before setting the job, and that method didn’t allow me to do that.”
Materials multiplier - Used mainly by small cabinet shops and small custom woodworkers, this method simply factors the price of the raw materials required to do a job and multiplies it by a certain amount, usually three or four, to determine cost. This method is also skewed easily by the price of the material. If you switch from oak to mahogany, the cost of the project could easily triple, pricing you right out of competition. Most experts agree that this method is dangerous and works many times by accident.
“A lot of people started out using the materials multiplier formula, but once you understand more about running a business and the profits you need, you realize it doesn’t work,” says Benbow. “If you have very low overhead and you’re working out of your truck, you could probably live on it, but if you have a shop, you’ll probably be losing money.”
No matter which estimating method you use, experts recommend you job cost, that is check the actual costs required to complete a job against your estimate. Job costing is a great way to pinpoint inefficiencies — those gaping money pits that suck the profit out of your work. Make it a regular habit at the completion of each job — it's the best way to ensure your business is running lean and mean and poised for future success.
Estimating software can make estimating easier than manual estimating methods with homemade spreadsheets that require extensive programming time and may be prone to errors.
“We used to use a manual linear pricing method, which proved adequate, but ineffective in figuring out if there was a problem and exactly where it existed,” says Scott Degenova, executive vice president of Custom Veneered Interior, Algonquin, Ill. “Tradesoft’s ProjectPak program now allows me to estimate the way I’ve always wanted — pricing a project down to its intricate details. Instead of having to look at the project as a whole, I can look at it in small parts.”
In addition to calculating figures and totals (and reducing the chance of human error), many programs automatically adjust rates and prices with the click of a mouse and allow you to break out labor and material costs.
“Your pricing is always changing, as it depends on market conditions,” says Joe Delude, president of Cabinet One, Clarksdale, Mich. “With the estimating software, I easily can fine-tune the numbers. If I want to upgrade a door style, I just pull that formula out and put another one in, and the software changes the price.”
Estimating software also allows you to recall data from previous jobs to improve consistency in your bids from one job to the next. You can build an extensive library of raw materials and labor operations and have access to detailed data that can make your next estimate quicker and more accurate.
“It allows us to create assemblies based on labor and materials, say a base cabinet,” says Paul Jutras, president of Jutras Woodworking, Smithfield, R.I., who uses TradeSoft’s ProjectPak software. “Once you call up that assembly, the program knows it takes a certain number of hours to build this cabinet with a certain price of material and hardware. It incorporates that information to create an accurate estimate.”
A competitive advantage software users see is in the speed in which they can complete an estimate — enabling them to be the first to the customer with an accurate estimate.
“The benefit of estimating software is in the repetitive nature in the types of bids you do,” says Spitz. “When you see the same types of cabinets over and over again, it becomes quick and efficient to estimate. Most bids done on the software will take a minimum of 30 to 45 minutes to complete. But once you have enough assemblies built into the software’s library, it really goes fast.”
Another timesaving feature that estimating software has over manual estimating is the ability to make changes quickly after the estimate has been created.
“If your customer says, ‘I don’t want to use melamine interior, I want to use maple,’ you can change the whole estimate with a couple clicks of the mouse from melamine to maple,” says Jutras. “That’s a lot more difficult and time-consuming to do by hand.”
No matter what estimating method you use, a software package may significantly increase your business’ chance to compete in the future.
“The home products industry has very tight margins and is very competitive,” says Jim Noss, strategic product director for software company Friedman Corp. “To have a system that is accurately giving the right information based on realistic manufacturing costs is the edge that is needed to compete.”
First determine the yearly salaries of employees. Presume the shop owner in our example wants to earn $60,000 for himself and $40,000 for his employee, for a total payroll of $100,000 per year.
Next, figure the total labor hours in a year. In this case, 40 hours a week times 50 weeks times two employees equals 4,000 total labor hours per year. Divide the total payroll by the total labor hours to develop your average labor rate. In the example ($100,000 divided by 4,000 hours), it works out to an average of $25 per hour per man, or $30 per hour for the shop owner and $20 per hour for the employee, depending on how you want to break it down for estimating purposes.
Don’t forget you still have to factor in your overhead and add that to your labor rate in order to recoup the expenses of running a business.
Reprinted with permission from Modern Woodworking.