Cost of Goods
The importance of knowing what expenses constitute Cost of Goods and what expenses constitute Overhead are critical to establishing a meaningful Chart of Accounts. A meaningful Chart of Accounts gives you an advantage in calculating your breakeven pricing; which in turn directly affects profitability.
A good general rule of thumb to distinguish between Cost of Goods (Direct Costs) and Overhead (operating or fixed costs) is whether they are a cost directly attributable to producing revenue and are they items that will likely increase as we obtain more work? Thirdly, can they be charged to the job? Usually items like direct labor, benefits for the direct labor, and materials fit these criteria. If an item does not meet these criteria then it, more than likely, needs to be treated as Overhead.
As noted above; that all items to be considered as Direct Costs (Cost of Goods) must be billable to the job and included in the estimate. If we leave things out like supervision, costs associated with bidding, consumables or if you cannot or won’t bill them; then it may fall into the “semi-direct” category that should be a Direct Cost but now is treated as a fixed or Overhead Cost so that we can recover this expense.
If, for instance, you have an owner/manager doing some office work, some field work, in addition to some direct job supervision, you must decide on how you are going to treat this expense. Should we divide it between Overhead and Cost of Goods? If so, how much do we charge each job for the supervision? Remember that items like supplies that are consumable may be charged to the job as a percentage of the revenue. For example, if over the years we have found consumables to constitute 1% of the overall Company job expenses; then this percentage could be added onto our bid in order to recover those costs.
MOST IMPORTANTLY – YOU MUST STAY CONSISTENT!! Treat it the same way each time. Know where the costs are. Are they estimated in the Direct Cost, or are they captured with the Overhead Recovery Factor and you structure your bid accordingly.
Overhead is operational expense not directly billable to a job. So how do we “charge” for the Overhead? Failing to recover the full costs of your Overhead in your estimating or pricing, will more than likely make your business, product or job unprofitable, when the final numbers are applied.
So, what constitutes Overhead? It is often referred to as “Fixed Costs, ” i.e., expenses that are not or cannot be included in the Cost of Goods because they do not meet the two criteria we have previously outlined. Another way to think about Overhead is to regard it as all operational costs that cannot or are not able to be billed to a job.
Generally, they do not vary from month to month (rent) or with the amount of goods or services or revenue we produce. Granted utility bills will vary slightly and phone bills will also, but as a rule they stay within a short range of expenses. They are also expenses that are incurred even if we don’t make one sale or never open the door. They are the “support systems” of the sales, manufacturing, or services that we provide. For example, rent, utilities, administrative salaries, liability insurance are all good examples of Overhead. Generally, they do not increase as we produce more work or provide more services. They are the non-direct” costs associated with running the business. However, we need to recover the cost of these items over the course of the year for you to stay in business. Failure to do so will put you out of business very quickly.
A separate account in Overhead should be set up for any office vehicles; (owner, estimator). This then enables us to charge each job or build into the estimate the costs for operating the trucks assigned to the crews. One such gray area might be job Superintendents. Are we including something in each job to cover their salary and benefits? If not we may need to treat it as a semi-direct and cost and recovery this expense as part of Overhead.
Determining breakeven is essential to the success and profitability of a Company. However, to achieve this goal you must determine the appropriate classification for all operational expenses whether they be Cost of Goods or Overhead. These items must be accurately tracked in your Chart of Accounts with proper input into each account on a consistent basis.
At Cogent Analytics, we never stop looking for ways to improve your business and neither should you. So, check out some of our other posts for helpful business information: