The Hidden Costs of Doing Business

It's no secret that while the entry barriers for remodeling are relatively minor compared to other industries, the rate of survival is low; the number of unfamiliar trucks that show up in your town — only to disappear within a year or two — is evidence enough of that. Many costs associated with a remodeling business aren't readily apparent to newcomers, and by the time they become apparent, it's too late.

However, these costs aren't completely invisible. Take workers' compensation insurance, for example. “The reason insurance hurts people in their first year is that they don't know how much business they're going to do, and what payroll is going to be,” says Robert Criner, owner of Criner Construction in Yorktown, Va. “A lot of people aren't prepared for a bill at the end of the year,” he continues, noting that monthly premiums are based on estimates of payroll levels, and that discrepancies must be reconciled at year's end. In his second year, a smart remodeler adjusts accordingly. If he's still in business, that is.

Unfortunately, there are still some costs that can ambush you years down the road. Every remodeler interviewed for this story said he still encounters surprise costs from time to time. It's impossible to compile a list of these “hidden” costs, but studying an example or two should give you an idea of where to look for them.

Some hidden costs may be lingering right under your nose, lurking in line items already in your budget. These can be particularly costly because they are so difficult to find; you think you're accounting for something, so you don't consider it a possible culprit. The good news is that once you do uncover such costs, they are relatively easy to take into consideration.

Labor is a prime example. Surely, you budget for that. But do you factor in the time it takes to set a job up in the morning, and to clean it up in the afternoon? If you calculate your labor based on eight hours of productive work per man, then you are shorting your estimate. If setup and cleanup take just half an hour per day, that's still 20 “lost” hours per man on an eight-week job.

And what about supervision time? Lead carpenters spend a significant chunk of their day arguing with subcontractors, talking to the homeowner, and instructing other crew members. Paul Eldrenkamp says he tells his clients that the lead carpenter “spends two-thirds of his time with his toolbelt, and one-third with his cell phone.” To that end, Eldrenkamp's company, Byggmeister Associates, in Newton, Mass., allows for between 8 and 16 hours per week of supervision time for leads, depending on the project's complexity.

Pinpointing these types of underestimated labor costs is difficult. You might eventually notice that a job wasn't as profitable as you had planned for and that the work took longer than you anticipated. But until you figure out why, you'll still be guessing when you go to estimate labor for the next job.

Another instance where remodelers commonly lose money but don't realize it comes when they hire a new office employee. It's not enough to increase your volume by the amount that the employee costs you; to maintain your profit margins, you need to increase gross sales by enough to absorb all of the new overhead costs.

In short, you need to find your “break-even point.” It's a relatively easy calculation to make, and it applies here because you are trying to determine the volume you need to add to keep a consistent profit margin. Simply divide the amount your new office employee costs you (salary plus all taxes and benefits) by a decimal representation of your gross margin percentage.

For example, if you plan to pay your new office manager $20 per hour, taxes and benefits could bring the total hourly cost to, say, $28, or about $56,000 per year. If your gross profit margin is 25%, divide $56,000 by 0.25. The answer is $224,000, which is the amount of additional revenue you need to generate annually to both cover the costs of the new employee and maintain your gross profit margin. Adding less revenue than that reduces net profit, and can even lead to operating in the red.

A remodeling business incurs other “hidden” costs annually. Newcomers will be able to include them in their budget with relative accuracy once they get a few years under their belt (or if they talk with enough veteran remodelers when they first start out). Criner knows from experience, for example, that call-back work averages one-quarter of 1% of his annual volume, so he incorporates that — and similar expenses that are consistent from year-to-year — into his markup. A younger company might not have an exact number, but it's important to “put something in, because a lot of things can go wrong,” Criner says.

On the other hand, a remodeling business may not encounter some costs for many years. Criner, for example, had a new hire take advantage of a company charge card. It's impractical to include a line item in your yearly budget that specifically covers employees stealing from you (something that may only occur once or twice, if ever, during your career), but it is possible to bump up your markup to accumulate a cushion of capital in case it ever does happen. In fact, a cash reserve can come in handy for a variety of unforeseen circumstances, including insurance claim deductibles and even economic downturns.

Paul Winans, of Winans Construction in Oakland, Calif., says that although he's “desperately looking for perfection, there's no way to get it perfect. If you [budget] from the point of view that it is, you'll have hidden costs that will bite you in the butt.”

This underscores the importance of thorough job costing. Every expense incurred on a job must be accounted for. Estimating at Winans Construction is done on a spreadsheet that fills more than 3,000 rows, including instructions. It wasn't always that lengthy; it's a fluid document, Winans says, with additions made based on meticulous job costing that tracks time down to half-hour increments and includes line items for things such as time spent placing orders.

To make such a detailed job costing system work, however, you need to impress upon your employees the importance of carefully tracking their time. It will probably seem odd to a lead carpenter when you ask him to track his time like a lawyer would, but it's vital to effective job costing.

Eldrenkamp says that in his case, as in many others, it took some time for his estimating to catch up with his slippage. At Byggmeister, Eldrenkamp insists on continuing job costing throughout the full course of a project, no matter what. “There are people who will do job costing until the job really starts tanking, then stop doing it,” he says. One key was bringing in his lead carpenters to assist.

“It's valuable to get their feedback on the actual estimate as the job is in production,” he says, “so we can talk about what led to overruns and take advantage of that information for the next estimate.” This process has led to revelations that have in turn spurred adjustments in estimating, such as including more management time for a bathroom that has no staging area.

Along those same lines, you, as company owner, need to be honest with yourself about your role. It's tempting for a company owner to simply “take what's left over” at the end of the year as pay. But doing this has consequences beyond your personal financial risk. “If you don't pay yourself, you have an invalid picture of the health of your business,” says Clai Porter, president of NCP Design/ Build, in Anchorage, Alaska. That includes paying yourself for — and charging clients for — your time. It's a good idea to bill as much of that time as you can as direct costs, but some of it inevitably will fall under overhead.

In fact, time you spend that would fall under indirect costs is another “hidden” profit leak. Porter says it takes him six months to a year to get a new lead carpenter up to speed with the company's systems and processes. It's obvious that the lead won't produce at full capacity during that time, but many owners forget to budget for the hours they spend doing that training.

Even more conspicuous is the time spent on implementing new initiatives. “Getting an idea out of someone's head and onto a form that someone else can be trained to use is very valuable to the company,” Winans says. But it takes time, is inconvenient, and, Winans adds, “the people who know the most are the least likely to have the time to stop and write it down.” So you need to budget for it, even if that means putting it off for a little while. Criner, after nearly 30 years in business, is still budgeting time this year to work on putting into writing the company's best practices and procedures. “It's not so much the time it takes somebody to write it,” he says, “but the time it takes to have the whole company meet [regularly] to go over it.”

The underlying theme here is that time is money, and that doesn't refer just to hourly wages. Time you spend doing one thing is time you can't spend doing something else, and if “something else” is more profitable, then you're losing money. This concept is called “opportunity cost,” a term common to economists but foreign to remodelers who don't have a background in finance or business.

Opportunity costs manifest themselves in a number of ways. Eldrenkamp notes that the decision he made to buy laptop computers for all of his lead carpenters had financial implications that reached beyond what he paid for the machines; the investment would have little payback, and the money would not be available to be invested in something with a higher return.

“You need to be aware enough of your business to be able to step back and compare different ways of investing your resources — capital, talent, time — rather than assuming that the choices you make are going to have the best return on your investment,” he says.

This concept applies to every part of the business, including what jobs you choose to take. “Jobs that are labor-only are a bad investment of our time,” Eldrenkamp says. “We need to leverage our time against markup of materials and subcontractors.” This revelation was part of what inspired him to move to the design/build model; the return on hours spent in the office and on sales calls is higher than when doing competitive bid or negotiated contract work.

Eldrenkamp also uses opportunity costs to emphasize the importance of working as efficiently as possible. For example, assume that in one year one crew can complete six eight-week jobs. But if things go wrong and the jobs take eight weeks, they'll only be able to complete five in a single year. So not only is money lost on each individual job by being two weeks behind schedule, the opportunity to complete another job at a normal profit level is also lost. If that job happens to be worth $200,000, at a 5% net profit, not doing that “extra” project costs $10,000.