The Right Way to Recover Overhead Costs

By Mike Vorster, Contributing Editor | September 28, 2010
Mike Vorster

David H. Burrows Professor of Construction Engineering and Management at Virginia Tech. See ConstructionEquipment.com for full archives of "Equipment Executive."

Every now and then, you must be controversial and address a subject where your beliefs run counter to common practice. Overhead and overhead-cost recovery is one of these subjects.

The controversy has its roots in the difference between a dealer's shop and a contractor's shop. These are two different organizations with different objectives. True, there are similarities. Both use expertise, facilities, skilled management, trained labor, and expensive parts and supplies as inputs to maintain, repair and rebuild equipment. Both serve their customers by producing high-quality and timely work, and both profess commitment to reliability in the machines that pass through their hands.

They differ, however, in their outputs and the way they are paid. A dealer's shop is paid and balances its books by selling parts and labor marked up to cover indirect costs, overhead and profit. The more parts and labor sold the better, and the only limit is defined by competitive pressures and the wish to render "value to the customer." A contractor's shop is paid and balances its books by selling machine hours at pre-agreed internal rates. The more machine hours sold and the more completed construction produced by the machines the better. The performance of the machines is crucial to success; and the objective is to reduce parts, labor and overhead costs to the lowest possible level consistent with achieving required availability, utilization and reliability.

Two principles are important when deciding how to account for and manage overhead costs associated with running an equipment fleet.

  1. Overhead cost must be reduced to the absolute minimum. Every cost should be assigned to direct codes whenever possible. Fuel trucks can form a part of the direct cost of fueling, and lowboys can be charged to jobs benefiting from their service. Classifying cost as overhead should be seen as an absolute last resort.
  2. Mechanisms for generating overhead cost recoveries must be tied to easily identified, measurable and desired outputs. An output such as shop labor makes sense for a dealer's shop where labor sold is the output. It doesn't make sense in a contractor's shop where labor is an input. Contractor shops should instead tie overhead recovery to outputs such as total equipment revenue so that improvements in utilization, availability and reliability result in corresponding improvements in overhead cost recovery.

The difference between tying overhead cost recovery to either labor or equipment revenue is best explained by the example in the accompanying table. Total annual cost for owning and operating the fleet is $5.6 million with an anticipated gain of $70,000 based on the assumption that the fleet will work 95,000 hours at an average rate of $65 per hour. Labor cost is based on 16,200 labor hours at a rate of $47.54. The $320,000 in overhead covers rent, facilities utilities, indirect labor and miscellaneous supplies.

Recovering overhead as a percentage of labor, as is done in dealer shops and in many contractor shops, is a simple process. Overhead costs is recovered at a rate of $19.75 per labor hour ($320,000 ÷ 16,200), which when added to the $47.54 labor rate, results in a rate of $67.29 per hour.

Tying overhead to equipment revenues can be done in a number of ways. For our purposes, let's calculate overhead cost recovery at a flat rate of $3.37 per machine hour ($320,000 ÷ 95,000) with the balance of $61.63 ($65 - $3.37) available to recover the direct owning and operating costs.

In the labor scenario, let's assume that training and technology have enabled the company to improve labor efficiency and to reduce the required labor hours from 16,200 to 14,200. There will be an immediate gain of $95,080 (2,000 hours saved at $47.54 per hour) in direct labor, but the overhead budget will be short by $39,500 (2,000 hours saved at $19.75 overhead recovery per hour). It is counter-intuitive to have an improvement in training and technology result in a negative impact on overhead recovery. Not the situation you want to encourage.

In the equipment scenario, let's assume that efficiencies, training and technology have enabled the company to increase availability and obtain an additional 5,000 work hours. Revenue will go up by $325,000 (5,000 x $65 per hour), and more importantly, overhead recovery will improve by close to $17,000 (5,000 x $3.37) to help pay for the overhead costs associated with the training and technology. Exactly the situation you want to encourage.

So here's the controversy. Why would dealers who believe that reliability and performance are outputs arising from action taken to maintain, repair or rebuild a machine charge the direct cost of parts and labor plus a variable percentage based on reliability and availability to cover their overhead and margin?

Mechanisms for generating overhead cost recoveries must be tied to easily identified, measurable and desired outputs.

How Shops Differ
Dealer's shop Contractor's shop
Work orders play different roles in the types of shop. They form the basis for payment in a dealer's shop; they simply record data in the contractor's.
Inputs Expertise, facilities, management, skilled labor, parts and supplies. Expertise, facilities, management, skilled labor, parts and supplies.
How the customer is served High quality, timely work. Uptime and reliability in equipment maintained, repaired or rebuilt. High quality, timely work. Uptime and reliability in equipment maintained, repaired or rebuilt.
Outputs, how are you paid Cost of parts and labor marked up to cover direct and indirect costs, overhead and profit. Revenue or cost recovery based on hours worked. Availability and utilization of equipment in the field is critical.
The work order's role Records work done and marked-up cost of parts and labor. Forms the basis of payment. Records work done and cost of parts and labor. Forms the basis of the machine's history.

Labor vs. Work Produced
Dealer's shop Contractor's shop
The difference between basing overhead recovery on the cost of parts and labor as opposed to the value of work produced is summarized for both a dealer's shop and a contractor's shop. It clearly shows the advantage of basing overhead cost recovery on outputs and shows how important it is to break with the traditional way of accounting for and managing overhead when running a contractor's shop. It also raises an interesting question.
Base overhead cost recovery on the cost of labor and/or parts used to maintain, repair or rebuild a machine. The normal way of doing it. Parts and labor are outputs: the more sold, the more likely you are to recover your annual overhead and be in a position to lower your overhead rate. A frequently found way of doing it. Overhead recovery is incorrectly based on an input. The lower parts and labor cost, the worse overhead recovery becomes and the higher the overhead recovery rate must be set.
Base overhead cost recovery on equipment revenue as an output measure for the value of work done by the machine. Seldom done. Dealers could charge the direct cost of parts and labor and warrant their work by using a variable percentage based on reliability and availability to recover overhead and margin. Overhead recovery based on an output. The better utilization and availability, the more hours worked, the lower the overhead recovery rate can be set.

Cost-Recovery Example
Owning Costs $1,500,000
Total annual cost in our example is based on 95,000 hours of fleet utilization and 16,200 hours of shop labor.
Operating Costs
• Parts $1,940,000
• Labor $770,000
• Fuel $1,100,000
Total $3,810,000
Overhead $320,000
Total cost $5,630,000
Revenue $5,700,000
Anticipated gain $70,000

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