When you own a small business you wear a lot of hats. Understanding the numbers is an important part of your business because they tell you how you’re doing financially.
One set of numbers is your profit and loss statement (P&L), usually generated from your accounting software. Another set of numbers is your estimated cost. I want to explain:
- how and why there needs to be a relationship between the costs you estimate for each project and your profit and loss statement, and
- how to calculate the labor rate used in your estimate, usually called the burdened labor rate.
The Basics
The first section of your Profit and Loss statement is Cost of Goods Sold. If your accounting is done properly, the only items in cost of goods sold are the same items you include in your cost estimate.
These phrases are practically interchangeable, because they all represent direct job-related expenses:
- Estimated costs – the costs you expect it will take to build a given project. If you have difficulties estimating a job, we have a class available.
- Job costs – the costs actually incurred to build that project.
- Cost of goods sold – an accounting term for the costs paid to build all projects over a given period of time, such as last month, last year, or current year-to-date.
The second section of your Profit and Loss statement (P&L) are your overhead expenses. These are all the costs that are incurred over a number of jobs. Overhead includes your salary, office expenses, advertising, job superintendent if they manage more than one job at a time, and more.
The book Markup & Profit Revisited explains what should be considered a job cost and what is an overhead expense in a construction business, but accounting for labor is always an issue. The base pay for workers on a job is always job cost, but some of the labor expenses are often considered overhead.
When you estimate the labor required for a job, you can multiply the estimated hours by the base rate you pay your employees, or you can use a burdened labor rate.
Labor Burden
A burdened labor rate includes the “labor burden”. The labor burden is the additional hourly cost of an employee. You might pay an employee $20 an hour, that’s their base pay or labor rate, but they cost the employer more than that. The employer pays federal payroll taxes, unemployment and workers compensation insurance, and more depending on your locale and the benefits you offer. The actual hourly cost of an employee is called the burdened labor rate.
Side note: If you’re doing time and materials work, a burdened labor rate is not the same as a charge rate. A charge rate includes the overhead and profit that you need to stay in business because that’s the best way to include overhead and profit in your pricing. You can include overhead and profit as a markup on material, but a 50% or 100% markup on materials is difficult to explain. You can calculate your charge rate with our Markup Calculator.
Your burdened labor rate is calculated by dividing your estimated total annual labor costs by the number of hours that you expect will be spent on jobs. It’s easier than it sounds. You need two figures: Estimated total annual labor cost, and the number of hours you expect will be spent on jobs. You can calculate it for each employee, or you can lump all employees together to come up with an average.
The rate won’t be exact, it’s a ballpark figure only, but it’s more accurate than using the base pay (labor rate). If you don’t want to walk through a calculation, many contractors assume that 35 percent of their labor rate will cover their labor burden. If an employee is paid $20 an hour, they assume the actual cost is $20 x 1.35, or $27 per hour. That might be close enough. You’re in business to provide a service and make a profit doing it, and fussing with numbers doesn’t get the sale made or the job done. On the other hand, you can calculate your own percentage fairly easily.
Calculate Labor Burden Hours
I’m going to show an example; replace the figures and assumptions with your actual experience or expectations. We’ll start by determining the number of hours you expect to be spent on jobs over a year.
There are 52 weeks in a year. There are five working days a week, which means (52 x 5) 260 days in a year. You might have ten vacation days and ten holidays over a year, so deduct 20 days. It doesn’t matter if you pay for those vacation and holidays or not, we’re calculating hours here. We want to estimate how many hours an employee (or all employees) will spend on jobs in a year.
My example employee puts in eight hours a day, which gives us (240 x 8) = 1,920 possible working hours. (We won’t address overtime yet.) Now deduct any expected “not on the job” hours.
These would be the hours that aren’t included when you estimate a project. There might be weekly company meetings, or maybe you know they’ll spend the equivalent of two full days a year working in the shop or cleaning out company vehicles. Maybe you know they spend an average of 15 minutes a day standing in line at a supplier. If you don’t include travel time in your estimates, then travel time is “not on the job” time and needs to be deducted here. The goal is to get down to only the hours that are actually spent working on a job.
For this example, I’ll deduct one hour a week in meetings (48 hours a year), and an average of thirty minutes a day spent traveling, waiting at a supplier, or standing in the office drinking coffee and getting instructions before they head out for the job (120 hours a year). I’ll deduct another 20 hours a year for cleaning up the shop. That means I expect they’ll spend (1920 – 48 – 120 – 20) 1,732 hours a year actually working on jobs.
Calculate Labor Cost
Now estimate the total labor cost over a year. It’s actually easier. In this example, I’m going to assume the employee receives paid vacation and holiday time. I’ll assume average Washington state worker’s comp, and guess at an unemployment insurance rate.
- 52 paid weeks a year at $20 per hour means a base pay (52 x 40 x $20) of $41,600 per year.
- The employer’s share of federal payroll taxes are 7.65 percent of pay (41,600 x .0765), or $3,182 per year.
- The employer’s share of worker’s comp is $2.4246 per hour worked (1920 x 2.4246), or $4,655 per year. (You could argue that meetings and supplier visits aren’t hours worked, but I don’t know if you’ll win that argument with the state.)
- Let’s assume an unemployment insurance rate of 4 percent of total wages ($41,600 x .04), or $1,664 per year.
The total labor cost ($41,600 + $3,182 + $4,655 + $1,664) is $51,101 per year.
Calculate Labor Burden
Divide the estimated total annual labor costs by the number of hours you expect will be spent on jobs. In this example that gives us a burdened labor rate of ($51,101 / 1,732) $29.50 for an employee who is paid $20/hour. That’s an additional $9.50 over their base pay, or ($9.50 / $20) 47.5 percent of pay.
Now that you have an average labor burden, multiply the base pay for each employee by 1.475 (or whatever your figure is) and you have your burdened labor rate for that employee. It should be reasonably consistent even if you have a lot of overtime, because most of the costs are directly tied to wages or hours.
Labor Burden and Cost of Goods Sold
The easiest thing from an accounting point of view is to include everything in the labor burden that can be easily entered as cost of goods sold. The payroll taxes listed above are easy because they’re entered in the books as payroll expenses at the same time labor is entered. If you provide cell phones to your employees (a practice we discourage unless they are a job superintendent), consider how the cell phone is paid. If one bill is received for all phones, put cell phones in overhead and don’t include it in the burden rate.
The same goes for health insurance; it’s probably paid as one bill for all employees, including office staff and owners. Health insurance is also usually a fixed amount regardless of the hours worked. Although some believe otherwise, I think in most instances health insurance should be included in overhead, not in your labor burden. There isn’t any advantage to placing it in labor, and a fixed monthly cost per employee might distort your burden rate if you have a lot of overtime or some employees are paid more than others.
Do what works best for your company. There aren’t any rules except the rule of consistency: When you calculate your markup:
- Whatever you include in your cost estimate for a project (such as all costs in your labor burden) should not be in your overhead.
- Whatever you don’t include in your cost estimate needs to be in your overhead.
Now, your cost of goods sold on your P&L will represent the same items you include in every cost estimate. That allows you to quickly check your P&L to see how good your markup is. Your cost of goods sold is comparable to your cost estimates, and your markup factor should match your overhead expenses and net profit. If you multiply cost of goods sold by your markup, you should be reasonably close to your total revenue. It won’t be perfect, especially if you’re only looking at a month or a quarter, but by looking at an annual P&L you’ll get a fairly decent idea of how well you’re pricing your jobs.
Summary
There are only two reasons to keep track of the numbers in a business. One is to fill out the paperwork required by the government so they know how much you owe in taxes. The government cares about the bottom line, the net profit or loss. It doesn’t really care about the details.
The more important reason is so you can see how your company is performing financially and look for ways to make it better. For that, it helps to have your books setup properly. The P&L should serve as a decision-making tool for the business owner, and that’s much easier if the accounting matches what you are doing on a day-to-day basis, which is estimating jobs and calculating prices.
The knowledge and experience Michael Stone gained in his 60+ years in construction has helped thousands of contractors improve their businesses and their lives. He is the author of the books Markup & Profit Revisited, Profitable Sales, and Estimating Construction Profitably, and is available for one-on-one consultations.
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