5 Ways to Unveil Margin Mirage

By Mike Vorster, Contributing Editor | July 2, 2019
The data in this example expose how understanding the difference between charges and costs affect profit measures.
The data in this example expose how understanding the difference between charges and costs affect profit measures.

The way in which equipment rates and the job charging system impact job margins and company profitability is one of the most controversial subjects that I encounter on a regular basis. Under-recovered equipment costs must be absorbed somewhere in the organization, and job margins can easily disappear in the year-end statements. I call it margin mirage: The job-level margins are not quite as good as they looked when the job was completed.

Let’s set up a simplified profit and loss statement for an example company and use it to understand how things work.

Our example company has generated $100,000 worth of contract revenue by being paid for work done safely, efficiently, and to the required quality. The direct job costs involved with producing this work come to $83,000. This leaves $17,000, a job margin of 17 percent. Let’s look at the direct job costs in more detail.

The cost of labor was $40,000. This is a firm hard cost. Everyone was paid, checks were written, and the money was spent. The same is true for the $6,000 in external equipment, and the cost of materials, subcontractors, and job indirect. They are all true costs, and the numbers are shown in green: We used real money to pay external organizations.

The internal equipment category is different. The number is shown in blue because it is a charge: We used a standard rate and an internal charge-out system to bill jobs for the company-owned equipment used on the project. The standard hourly, daily, or monthly rate for each unit is in itself a complex estimate. The internal charge-out system used to generate the internal charges is also complex and controversial (see “How to Recover Equipment Costs”). The important thing is that there must be a reasonable and reasonably accurate way to charge jobs for the resources used to build the work, and there must be a routine and systematic way to calculate job margin.

Total direct job costs is a mix of true costs—the numbers shown in green—and internal charges— the number shown in blue. Job costs are not all “costs” in the true sense of the word, and a job margin that contains some internally generated charges in its calculation cannot be seen as a final hard number.

We therefore need a way to eliminate the “blue money”—the internal equipment charges—and replace it with “green money”—the true cost

We therefore need a way to eliminate the “blue money” —the internal equipment charges—and replace it with “green money” —the true cost of owning and operating our fleet. This is all but impossible at a job level, especially if jobs are small and quick, but it can and must be done at a company or divisional level. At that point, one can compare the total of all the equipment charges billed to jobs and determine the true cost of owning and operating the fleet.

The calculation is shown in the bottom half of our example.

Here we see a summary of the equipment costs experienced split into the four main categories: owning, operating, fuel, and indirect. The total comes to $19,600. The numbers are all green because they are all true costs. Well, not quite true. The owning costs of $5,500 are most likely a blend of true owning costs such as licenses and insurance and some internal depreciation charges used to write down the capitalized value of company equipment. That discussion is beyond the scope of this article, so let’s accept, for now, that the true cost of owning and operating the fleet comes to $19,600.

The reconciliation between costs and charges comes in the last portion of the calculation where we calculate the under-recovered equipment costs by deducting the $16,000 in equipment charges from the $19,600 true cost experienced in owning and operating the fleet. The $3,600 under recovery must, of course, come off the $17,000 job margin in order to determine the gross profit from operations of $13,400.

In other words, $3,600 of the job margin was a mirage due to the fact that the job charges for internal equipment were $3,600 less than the true cost of owning and operating the fleet.

We learn five things from this exercise.

1) Understand how the system works. It is important to know that internal equipment job charges are not costs. The job most certainly sees them as a cost in the calculation of job margin, and the equipment manager sees them as a revenue when seeking to balance the equipment account. But in the end, they are “blue money” that cancels itself out in the calculation of gross profit from operations. That is not to say that they are not important. They play a major role in defining job margin and in setting the budgets needed to manage the equipment account.

2) Accept that it is not an exact science. Many things influence the true cost of owning and operating a fleet of construction equipment, and many expenditures—especially the big ones—come in spurts at random points in time. The standard rates used and the cost-recovery system developed to charge jobs will never replicate or precisely match the way in which equipment owning and operating costs are experienced. Know that there will be differences between recovered costs and actual costs; know where and why they occur and have a plan to manage them.

3) Set standard rates, and define a practical cost-recovery system that will fairly and properly recover the costs expected for each class of equipment in the fleet. Calibrate the rates periodically to ensure that they stay in line with reality, and know when a given class of equipment is over- or under-recovering its true costs. Balance the equipment account by class, and do not permit the dozers to subsidize the haul trucks. Set reasonable control limits for equipment cost recovery for each class and for the fleet overall. Take action when limits on over- or under-recovery are exceeded. Know what is going on and do not permit under-recoveries in the equipment account to cause job margin to be a mirage. Work to achieve a situation where a small over-recovery in the equipment account can boost job margins.

4) Use the same standard rates and cost-recovery system to drive job costing and the calculation of job margin. Charges for equipment on the job must flow easily and seamlessly as debits against the job and credits to the equipment account. Nothing is achieved by trying to use two systems, one to debit the job and one to credit the equipment account. Use the same standard rates and cost-recovery system in estimating so that any difference between estimated job costs and actual job costs can be attributed to increases or decreases in productivity and not to changes in the way in which equipment charges are calculated.

5) Know that  gross profit from operations depends on the difference between revenue,  the red number, and cost, the green numbers. Focus on what must be done to reduce cost and not on what can be done to game the system. Under-reporting hours worked or artificially suppressing rates may increase job margin, but it won’t change gross profit. Remember you put “blue money” into the system when you determine your internal equipment charges and you take it out of the system when you determine your over- or under-recovered equipment costs. Blue money does not, in the end, affect gross profit from operations.

Standard rates and the cost-recovery system play an essential part in estimating, cost control, and equipment cost management. They can motivate and improve performance. They can also drive a wedge between operations and equipment and lead to the false belief that you can succeed by gaming the system. Knowing how it works should help keep everyone focused on the real issue at hand: an improved gross profit from operations.

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