It's hard to think of a more important business task of a drilling contractor than to develop a detailed picture of his costs of doing business. Failing to do this is like flying an airplane without a fuel gauge. You might make it to your destination, but can you be sure?
There are four basic components to the price you charge for any job: 1. Materials. 2. Direct costs. 3. Indirect costs (overhead). 4. Profit.
Material costs are simplest to measure. You know exactly how much you pay for pipe casing and other materials going into a particular job. If you stock inventory and take it out of there, it's pretty simple arithmetic to identify what you paid for the bulk purchase and divide by the amount going into a particular job.
What's not so easily figured is the amount of consumables used on a given job. Nobody keeps track of ounces of oil and grease or how many screws and nails get used. However, this doesn't mean you ought to give all of that stuff away free. The best way to handle consumables is to assign their cost to overhead. We'll get to that in awhile.
Direct CostsDirect job costs also are relatively easy to calculate. The greatest direct cost will almost always be labor, including wages and benefits. Other direct job costs might include permits, changes and perhaps consulting fees for some types of work.
How about all those niggling little "favors" you do for customers that cost just a little and don't seem worth the trouble of putting together a change order or invoice? Consider this: would you be willing to eat a job change that costs $1,000? The most likely answer is, not while you can still draw a breath to protest. Yet, over the course of a year you may well end up doing 10 "favors" for customers that cost $100 apiece, or maybe 100 real little ones costing you on average $10 each.
Contractors are caught between a rock and hard place when it comes to "little" requests. It might well lead to bad vibes with customers if you keep saying no, but you can get nickeled and dimed to the poorhouse if you keep picking up the tab. A solution might be to keep track of all the minor changes and favors, and convert them into one line item on the final bill labeled "customer requested minor changes" or "customer requested extras." Alternatively, you can build a cost factor into overhead that gets charged to every job you do. Just stop paying for everything out of your own pocket.
Hourly OverheadLast month I wrote about the missing ingredients many contractors fail to account for in overhead. Once you have a good handle on things that comprise indirect costs (see box), you need to come up with a number that is second nature to financial managers in big business but rare among drilling contractors. You can be sure financial managers for FedEx and UPS have figured out to the penny how much it costs to deliver a pound of package one mile. Likewise, McDonalds has a handle on what it costs to serve each item on its menu, not only ingredients, but including labor and overhead charges. It would be hard to find a Fortune 500 financial executive who doesn't know what it costs to deliver a unit of the company's products and services.
Your basic product is the labor used to put holes in the ground. Do you know how much it costs to deliver an hour of that labor ó not just the direct cost of wages and fringes, but with overhead burden added to it? (Alternatively, you might prefer to calculate overhead on a per-foot of drilling depth basis, although I suspect labor would entail fewer variables.)
Congratulate yourself if the answer is yes. Probably fewer than 10% of drilling contractors actually do. Most are just guessing, and they almost always underestimate.
What you need is a dollar-per-hour overhead figure you can plug into your estimates to tell you what you need to charge to break even. For instance, if your direct labor burden were $25 per manhour, you'd go broke charging that amount. You need to charge substantially more to cover indirect costs and profit. But how much more?
End The GuessworkNine out of 10 contractors simply come up with an hourly labor rate based on what the competition charges, or a few bucks less if they're hungry for work. Most don't have the slightest idea whether that's enough to cover their costs. They just cross their fingers and hope ó and then postpone paying bills until "cash flow" straightens out.
It's time to end the guesswork. What you need is to break down your overhead into a dollar-per-hour amount that, when added to your labor and other direct costs, will reveal your breakeven cost of labor. (We'll get to profit next article.) The arithmetic is quite simple; what's usually lacking in the real world is adequate recordkeeping. The more precise your numbers the better, but lacking a track record, you can come up with a reasonable estimate based on:
A. Your total overhead cost over a reasonably long time period, at least the last three months.
B. The number of labor hours you billed over the same period. This is the total number of manhours you factored into your job quotes over that time. Add them up.
Now divide your total overhead in dollars by the number of billable hours of labor in the given time period. Use only hours actually billed to the customer, not all hourly wages you may have paid your men for work not charged to specific jobs. Unbillable labor hours, or "overages" on jobs that took longer than expected, are best accounted for in overhead, in my opinion. Many accountants would prefer that you assign them to the direct cost ledger. Let's not split hairs over this. The important thing is they be measured and accounted for in some way.
The resulting number will be your dollars-per-hour overhead burden. Added to your hourly labor charge, it tells you what you need to sell an hour of labor to break even. These numbers should be updated at least quarterly to factor in pay increases and other rising costs, along with changing business conditions that might alter the amount of work you book.
Most of you who follow through on this exercise are in for a big, disheartening surprise. You're likely to redo the arithmetic several times because you won't believe what it's telling you. But if you calculate correctly, the numbers don't lie.
Fact of the matter is many of you are about to find out you are selling your labor for less than it costs you to deliver it. More on this next month.