change in real terms, or dollar amounts, as the level of business activity increases. In addition, they tend to remain about the same percentage of direct costs. In other words, if direct costs increase from one year to the next by 15 percent, it is likely that as a group variable costs will also rise approximately 15 percent. An example of variable costs is the cost of travel expenses. When business activity increases, a company is more likely to have employees travel to more work locations for client meetings as well as work on the job. Other items we also include in variable costs are:
Did you know that equipment purchases can be depreciated over time, reducing the income tax burden? Depreciation can be a complex concept; we strongly recommend consulting with an accountant in order to receive the most favorable benefit from depreciating equipment.
An excellent way to plan for the future is to prepare a chart listing all of your depreciable equipment, such as vehicles and skid loaders, and projecting the useful life of each. Then estimate the replacement cost, adjusting for inflation. Knowing when and how much you will have to borrow for capital equipment is critical to both the current and future annual budget process. Saving for the future takes good planning and great discipline but is well worth the time and effort.
warning
In most states, price fixing of a product or service is illegal. Generally speaking, a company may not, with another company, agree to set a price for a particular product or service. However, conformity of prices for a particular product or service is not illegal unless the conformity was created in combination with other companies agreeing on a set price.
Some costs overlap between fixed and variable. These include items such as advertising. While the cost of advertising on a website may be constant from one month to the next, advertisements in local newspapers or magazines may be placed at irregular intervals—or not at all. The variable-cost budget for K&K Contracting given in Figure 6–5 on page 77 is fairly easy to understand. These are the costs that will change as business activity changes. We strongly recommend including a budget for “contingency.” Unfortunately, you cannot expect the unexpected—as when the United States experienced a jump in the price of gasoline to $4 per gallon. Employee incentives are in the variable cost budget even though they may not increase as revenues increase. However, they are certainly not fixed costs, and it would be a stretch to include them in direct costs. Because they are usually tied to employee performance, the best place for them is with variable costs.
FIGURE 6–5: A Sample Variable-Cost Budget
Well, now what? Direct costs, fixed costs, and variable costs are identified as the major components of a budget. This is all well and good, but what does it tell you, and how can you benefit from the knowledge gained from compiling these budget numbers? First it’s a valuable exercise that forces a business owner to correctly identify all of the costs of doing business. But more importantly, you can use the information to assist in setting prices for your products and services.
Now that you’ve identified three categories of spending, the next step is to combine two of them and give them a new name. Each will keep its own identity, but they work together to make what is called “overhead,” which is the ongoing general and administrative expenses that are not directly related to the selling of a company’s goods and services. To that end, you’ll combine fixed costs and variable costs to calculate total overhead expense. Using the example of K&K Contracting, combining these costs gives the following results:
Fixed costs = $187,484 + Variable costs = $ 86,120 = Overhead = $273,604
One way to consider overhead is that it supports direct costs. When money is spent specifically to generate revenues (direct costs), money is also spent in the office and elsewhere to support those direct costs. The budget you are developing will help you determine how you will generate revenues to pay for or to recover overhead expenses. The first step is to understand the relationship between direct costs and overhead. Consider this formula:
Total overhead ÷ Direct costs = Overhead recovery percent
And when we plug in our numbers:
$273,604 ÷ $597,293 = .458 or 46% = Overhead
What this means is that for every $100 spent on direct costs an additional $46 will be spent on overhead. With a little experience, it is fairly easy to determine the cost of materials for a project as well as the time estimated to complete it. Once this is accomplished, the cost of overhead recovery falls right into place.
Alternative Method
Some contractors, either by preference or because the competition demands it, allocate overhead only to their labor costs. In the case of K&K Contracting, when overhead is allocated to labor only, the overhead recovery rate is 114 percent ($273,604 ÷ $239,793). This may be acceptable for some companies, especially if the relationship between materials and labor is relatively constant. However, when the cost of materials is extremely high relative to the cost of labor, the result is usually to undercharge the client. The reverse is usually true when the cost of labor is high relative to the cost of materials.
In Figure 6–6 on page 79, the costs of four separate