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FMI Quarterly/September 2013/September 1, 2013

Contractor Challenges With the Dual-Rate Method

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Some of FMI’s earliest client work revolved aroundhelping labor-intensive contractors capture all of theircosts, so that profitability became intentional andplanned, rather than something that happened by accident. After all, FMI’s founder, Doc Fails, started out by trying to teach sound business and accounting practices to contractors, with the understanding that marrying business acumen to technical skills would lead to best-in-class construction organizations.

One of the key ways in which Doc Fails, and those who have come after him, helped to do this was by introducing the concept of overhead recovery using dual rates.

The resonance of the dual-rate method and its place in FMI’s history seems to be one of the many lasting legacies of Doc Fails, from the contractor who asked FMI to come teach it to a new generation of estimators, to the client whose father showed us his textbook from a pricing and bidding seminar more than 30 years ago. Recently, though, we have had some clients question whether it is still valid, given today’s tough market environment. What FMI has learned, more often than not, is that what looks like a failure in the method actually is driven by the implementation. In other words, there are a few consistent challenges we see with contractors who struggle to implement the dual rate method of overhead recovery.

Developing a dual rate overhead recovery model is well-covered in Landon Funsten’s “Making a Profit in Construction: Improving Your Overhead Recovery” (2002). Rather than re-plow that ground, we will focus on the most frequently seen challenges to successful implementation of a dual-rate recovery system.

CHALLENGE 1: HAVING YOUR EYES GLUED TO THE REARVIEW MIRROR

Cars have rearview mirrors so that the driver can glance backwards to use that information in driving forward. No driver would ever think to put the shift lever in drive and then look at the rearview mirror instead of the windshield. Yet, too many contractors use exactly this mentality when developing overhead recovery rates. The dual-rate method has always been a predictive tool. As part of the annual budgeting process, the contractor should identify what the expected revenues, direct costs and overhead will be for the coming year, and from these key variables derive the appropriate recovery rates.

Because the dual rates are derived from the budgeting process, it seems straightforward to say that contractors who do not budget cannot develop dual rates. Yet, some contractors claim to use dual-rate overhead recovery while simultaneously stating that they base those rates off historical data. Unless you expect to do exactly the same revenues next year as this year, with exactly the same cost structure, this will leave you either over-recovering and less competitive in the bid market (for firms with growing sales) or under-recovering and bidding too cheaply (for firms with stable or shrinking sales).

Even scarier are the firms that came up with a set of rates in the distant past that they have been using ever since. Barring truly exceptional luck, there is no way that the overhead recovery for these firms is anywhere near accurate.

CHALLENGE 2: CARVING YOUR DUAL RATES IN STONE

Another consistent difficulty contractors have in using dual rates is a lack of flexibility in the rates. Since rates are set based on a projected budget, if circumstances change significantly during the year, the budget should be revised, and with it the rates. In order to stay flexible, the contractor needs to consider each of the various elements of the budget that has an impact on the overhead rates.

Revenues
Since one of the key drivers of the budget is the expected revenues of the firm, any significant change in those expected revenues needs to be incorporated into the rate calculation. As an example, one of FMI’s clients in a market that typically slowed down dramatically during the winter was able to keep its revenues up due to a different mix of work and a mild winter. This firm was able to recalculate its rates to be more competitive on its work during the rest of the year because of higher-than-expected revenues.

Direct-Cost Structure
Another important element in calculating dual rates is the direct-cost structure of the organization. Since so much of the rate calculation is based on ratios of material, labor, equipment and subcontractors, significant changes in these ratios can again lead to over- or under-recovery of overhead costs. Consider the example of the following contractor, as seen in Exhibit 1.

2013q3_dual_rate_method_ex1This contractor obviously planned to self-perform quite a bit more work than it actually did. Maybe the firm decided to cut its exposure to labor risk by laying off a few marginally performing crews and instead subcontracted the work. Under the projected budget, the firm’s rate on labor would be 27.01%, and on materials and subcontractors, it would be 8.94%. However, if the firm had known it would be subcontracting that work, it might have made dramatic changes in its overhead structure to account for its revised management needs. Alternatively, it could have used rates based on its new M&S/L ratio of 4.8 — marking up labor by 44.36% and materials and subcontractors by 9.09%.

However, the firm’s change in cost structure, if not accounted for, would have a dramatic effect on overhead recovery. Under the changed cost structure, the firm would recover $675,250 on its $2.5 million in labor, and $1,072,800 on its $12 million in material and subcontract cost. This would limit the overhead recovery to $1,748,050 instead of the needed $2.2 million.

This example shows the dramatic impact that a change in the cost structure of a firm can have on its overhead recovery and the necessity of addressing these types of changes in bids going forward.

Overhead Costs
Another challenge in establishing dual overhead recovery rates is the impact of changes in the overhead structure of the company. If a firm reduces overhead by cutting staff or consolidating offices, it can lower its recovery rates. More frequently, firms make unbudgeted changes in their overhead structure without revising the rates, which leads to under-recovery of costs and reduction in profitability. Thus, it is important to update the recovery rates when the overhead structure changes in a significant way.

CHALLENGE 3: PROJECT SIZE MATTERS IN OVERHEAD RECOVERY

The purpose behind dual-rate overhead recovery is to try to capture all of the costs of construction by tying the overhead support required by the project to the project itself. Many contractors forget this fact and apply the same rates to all of their projects. However, a project that is much smaller than the average project will use overhead out of proportion to its size. In other words, no matter how small a project is, it still requires some accounting support, project management, estimating, etc. Likewise, a large project may use less overhead as a percent of cost than the average project. If a $2 million project requires one project manager, for example, it is unlikely that a $4 million project would require two.

To solve for this challenge, a job size factor should be used, based on the project’s size relative to the average size for the firm. This factor is derived from the job size of the individual project (Ji) versus the job size of the firm’s average project (Ja). Using the table in Exhibit 2, job size (Ji) and average job size (Ja) are measured in total direct costs, not selling price. In this table, Ji is the size of the job’s total direct costs, and Ja is the company’s average job size, measured in total direct costs. “Normal overhead,” hopefully determined through dual overhead rate, is then adjusted by multiplying that normal overhead by the Data Multiplier. In the table, the relationship between Ji/Ja and the corresponding data multiplier is based upon FMI studies of how overhead costs should vary as job size increases or decreases from average job size for a firm. For companies pursuing several types of work, departmentalizing the operating budget may be required, with consequent determination of dual rates by department and determination of average job sizes for each department.

2013q3_dual_rate_method_ex2

CONCLUSION: DUAL OVERHEAD RATE CHALLENGES CAN BE OVERCOME

The typical problems with implementation of a dual-rate overhead recovery system outlined above have solutions. Implementation of dual overhead application rates and job-size adjustment factors based solely upon the information of this article would be difficult. If the principles discussed here have piqued your interest, an FMI specialist can discuss implementation issues with you.

While the market is certainly less forgiving than it was just a few years ago, this is no reason to give up trying to accurately capture and recover all costs of a project, including the overhead support costs. In fact, it is more important than ever before to ensure that any projects your company wins cover all the cost of those projects.


Mike Clancy is a principal with FMI Corporation. You can reach him at 919.785.9299 or via email at mclancy@fminet.com.

 

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