One way of measuring the profitability of your company is to take a big picture look at your company’s finances. This type of examination usually comes at the end of the year as you examine annual budgets, spending goals, and discern the overall profitability of your company.
While there is useful information that can be gained from such a review, it doesn’t answer all the questions that arise in the life cycle of a business. This week we respond to a question from a listener who wants to know how to determine the profitability of individual projects, especially ones with variable costs. This type of question is not answered in your annual report, and its answers can help drive the profitability of your company.
On this episode you’ll hear:
- How to set up a project budget
- Why an annual report won’t answer this question
- How to determine the true cost of a project
If you are also looking for better ways to understand your company’s gross profit as it relates to individual projects, then this is one episode you won’t want to miss.
Transcription of This Episode
The Gross Profit Podcast is your one-stop shop on the path to profitability. Each week we share authentic advice on the positive practical steps you can take to make the company you love more profitable. If you are looking for a positive plan to help you avoid common spending mistakes, control costs, and increase your profits, then this is the place for you.
I’m Ryan Cowden, and this week we’re joined by James Kennedy and Garrett Carragher. In this episode of The Gross Profit Podcast, James and Garrett discuss a listener question about how to measure project profitability when there are variable costs. One way of measuring the profitability of your company is to take a big picture look at your company’s finances. This type of examination usually comes at the end of the year as you examine annual budgets, spending goals, and discern the overall profitability of your company. While there’s a lot of useful information that can be gained from such a review, it doesn’t answer all the questions that arise in the life cycle of a business.
This week we respond to a question from a listener, who wants to know how to determine the profitability of individual projects; especially ones with variable costs. This type of question is not answered in your annual report, and it’s answers can actually help drive the profitability of your company. On this episode you’ll hear how to set up a project budget. Make sure to consider employee cost, material cost and the overhead cost to determine the true cost of the project. Next, we’ll discuss why an annual report won’t answer this question. Annual reports do give you an overall picture of the health of your company, but it doesn’t get specific enough to analyze the gross profit of individual projects that your company chooses to work on.
And finally, we’ll have an in-depth conversation about how to determine the true cost of a project. We will share some ways to determine your charge-in rate, which is your employee costs plus your overhead to determine the true cost of a project. If you are looking for better ways to understand your company’s gross profit as it relates to individual projects, then this is one episode you won’t want to miss. There’s a lot of actionable advice in this episode, so grab something to write with because you’re going to want to take notes. As always, I’ll be back on the other side to wrap up any loose ends. So without any further ado, here’s our conversation with James and Garrett.
Hello, and welcome back to the Gross Profit Podcast, I am your host James Kennedy, CEO, ProcurementExpress.com and I am joined again by the secret CFO, Garrett Carragher. Garrett, how are you on this fine Sunday morning?
Good, good James lovely Sunday morning, and another beautiful rainy day here in Kildare, as always enjoying the weather.
Good, yeah. Well, nothing better to be doing than doing a podcast inside. There’s no beach to go to, obviously. So very exciting, Garrett, we have a listener question from one of our customers to talk about today. Let’s listen to the question, and I’ll fill you in a bit more about who sent it in and what it is after that.
Hey, secret CFO, I love your show. I have a question for you. We are growing our business. We seem to be adding lots of staff and lots of great things happening, but I don’t feel the profitability in the bottom line. It’s hard to measure. We do a lot of fixed-price contracts for our clients, and many of our costs are fixed, but some of our costs are variable, and it becomes increasingly hard to measure the profitability per project on certain projects; especially when they go over-time. We’d love to know your thoughts. Thanks.
There you go, James, so that’s a question from one of our listeners there.
Yeah, so I have some bit of context here. This is one of our customers where they actually produce animated explainer videos. They do them on a fixed-price basis. So someone wants a video to put on your website or to use in your advertising. And they have in-house copywriters, and animators, and outsourced voiceovers, and producers and as a team, they come together to create that project. But the cost, the price they quote the client is on a fixed basis. But obviously they have a bunch of variable costs and they’ve grown a lot in the last couple of years. Added more head count, but they’re have been tracking their turnover, which is easy to do I guess. And now they are starting to realize, oh hold on, we should really be tracking the profitability on a project basis, which is not as easy as it sounds.
Yeah. So yeah, exactly. So a lot interesting things from the listener. There’s a couple of things I picked up immediately there on what she was saying was. It’s trying to find out what a profit is, and trying to understand where’s the profit going or what’s the real cost when it starts, you start going all the time on a project. So, the first thing I would suggest the listener does is to set up a budget. So when you set up a budget, you should think about it. Most businesses would have like an annual budget. So, obviously you know you’re right there a lot of our listeners would be doing the accounts or maybe running the business themselves and they set up an annual budget. An annual budget is really to track how things are going and help to cash flow, understanding the direction of the business and where you can make more money.
But also you should also set up a, in this particular case, you should also look to set up a budget for each of the projects. So, that will immediately then let you and then let you know how your project is going, and give you something to trace back to like a baseline if you like to try and track back to see how it’s going. So, when we think about a project budget, there’s three main things that would make it up. You’re thinking about your employee costs, so maybe that’s done on the hours. You track that with your time sheets. You might think about material costs.
So, if you have any materials going in there or any other third party costs maybe like, subcontractors as well going in there. And you can keep an eye on that using a good PO system. And then you might look at your overhead costs. Now, I think in the questionnaire she was talked a lot about fixed costs. So a lot of your overhead costs would probably be fixed. So that would be like your rent, and light, and heat, any kind of rate to pay to local authorities. All that kind of stuff are usually done as fixed costs.
Time sheeting is something no one has ever said and rolling out our time sheets in a companies creative company like that, you’re going to get a lot of pushback. So I mean do you really have to go that far? Is there any other way? Cause you’re adding admin onto the staff there and staff who aren’t necessarily, they just care about creating a nice piece of work.
Yeah, of course. So, there’s two points that which you’re talking about pushback and admin. So, let’s take this one first. So first of all, admin, the admin is pretty simple should be pretty quick and most, most companies were billing, you know, 15 minutes of admin a day to fill out your time sheet or whatever you need to do. And the admin really comes down to, you know, it can be as simple as setting up spreadsheets and someone has a job numbers on it, on a shared spreadsheets, on people just type in their hours under a name and that’s it. So like very, very easy and very, very quick. And it can be as complicated or maybe even, you know, another way of looking at it as you can just get some simple codes online, software that will just allow you to record time sheets super quick and people can just log in and type in their, their hours against whichever job their working on.
So that’s the first part. I mean the pushback part then I think sometimes you get pushed back from people if they don’t understand the significant sort of reason behind something. So, even I can tell it from your loaded questionnaire James that you, you only think this is admin, but is it going to be from admin? Actually, what this is going to do is have the company to drive towards profitability by selecting jobs that are high margin. Okay? So if you don’t, if you don’t understand what jobs are making the profit on you’re not going to be able to drive to company in the right direction, and you’re going to start on the pricing and things like that.
So, you touched on something interesting there. So, for example, another way of determining your profitability would just be get to the end of the year and total what’s in the bank, what you owe people and what’s owed on that. You could say that’s your profit. So, you can do that with zero admin on the company. What’s wrong with that?
So what’s wrong with that is, that is usually done for financial accounts. I think we might have discussed one time in a previous podcast, so listeners should check that one out. But, that’s the difference between financial accounts and management accounts. Because financial accounts you report those in, you send in an overall number, it shows your profit. But if you really want to drive your business forward and understand where you’re making your money, where you’re losing money. Where you’re paying too much for materials or employees. Who your star employees, who’s making your highest gross profits. Which projects make the highest gross profits, and it’s important to add to monthly management accounts, have good management accountant who can run through those numbers for you, and produce. Take all the data and produce meaning meaningful information in a relevant and timely manner that you can go through and understand what’s going on in the business.
Like I have a quick anecdote if I can, if I may, James. I worked one time for a large bakery here in Ireland and they were an incredibly profitability business. And they wanted as you do to close down a competitor. Okay, so the way they chose to close down his competitor was they would give them, they would to take their business. So to take their sales. So the way they took their sales is they outsourced some of their banking to the third party. So, the company I was in was selling so more that she didn’t have enough capacity to meet to fulfill the demand. So to actually supply the demand. So, we went to this third party bakery, we really wanted to close them. And I said to them, we’re you know, we so much demand, I know you have bakery here, you know things aren’t going that well for you. You make some of our product and we sell it for you. And they were going oh yeah this is brilliant, this is brilliant. So, they went off and started making the product.
This is going to be bad for the company. So give them a really bad price. So we were saying you make this for us and we’re going to give you one Euro per product or per box or whatever. And in reality, like we were selling it for 10 Euro bucks. So we were seeing in this, this is going to close the other company. But guess what? They come back to us after six months then goes, this is great. You know, this is super, we’re just we’re going to invest in another line. Another, another production line. Right? So, our PR management going what is going on here. Why are you doing this? Why are you doing this? And you know what it was? It was down to the gross profit, because guess what, we had given them and only when we went through the numbers in detail that we find out, we give them one of the highest gross profits products to make.
So, even though we were only senators was a low price, they could make 5,000 of these items per hour on that particular line. I know we’re making a massive gross profit on it. So we’re making lots of money, but we didn’t realize it. So we went to Sydney, we realize it. So we went down to the head of a manufacturing head of production in the company, the head baker, and we went through it with him. So, he said instead of giving them the baguette to do, give them petty pond to do, so that they could only make I think it was 1500 of those in an hour. So, we immediately start to send that through gross profit drop massively. And in the end we were actually able to buy that company and the used… Take them over and just start using their line like it was our own.
But that just shows you there. If you don’t understand your gross profit, you can make big mistakes. And that was a big, big profitable business and it made simple mistakes like that. So for smaller businesses, even more important to understand what’s going on.
So for our listener there, it’s not all projects are created equal, and understanding which projects are making a better profit and which aren’t. Irrespective, you might have the turnover that are creating. It’s important to understand the individual profitability of the project is what we’re getting to, I guess.
Exactly, yes. It’s important. Understand which is profitable and understand your costs because maybe you need to charge it more on some projects, and maybe the market would bear a higher cost, but you don’t know that because you don’t know what your costs are. Your real costs are on a particular project. So you can be undercharging on some projects, overcharging on the others. You’re winning some based on you don’t know why, and you know you could be making any kind of profit. So that’s the key. That’s the first point I make. That’s a key point is it do a project. Have your hours there recording them on the time sheets, do your materials and sub-contractors record them a good online POS system, but then your overheads will also pull in.
And then the next point I would say, so you might say, well how do I measure this against what we’re actually doing? Or how do I measure the cost? I can measure that through a thing called the charging rate. So the charging rate is the fully full cost of an employee. So you might think the full cost of my employee is their salary or maybe their salary plus the government taxes. The fact there’s other costs associated with the employee because they have holidays, they’re not a hundred percent efficient, and then there’s little cost. So you need to include that with your employee costs and also pensions and stuff like that. And then you need to also to get a charging rate, you need to add in overhead costs, and also a better profits. So that would give you the full charging rate of an employee to understand how much they’re really costing you.
Interesting. I wouldn’t have thought about, so it’s not necessarily just our salary and taxes, but you get you, you’re making guess that everyone’s 80% efficient, I guess. And then you add that on to the, and do you just eyeball that, so whatever you assume everyone’s 80% or 90% efficient or, how’d you do?
Yes. You might, what you might do is you might just have a think about it. Normally what I would do is I have a spreadsheet here and I would look at the number of billable hours, the number of workable hours in a year. Then I would subtract from that buying holidays, I then take off the people’s holidays. So people might have 20 holiday, 20 days holidays or might have 20 days holidays when the public service, whatever they have and you just add in as well. And then that would give you a number of hours that they actually work in the ER. From there, you then get an efficiency on that. So you might say exactly, you might see these people should be 90% efficient, or should be 80%. So you might look across industry standards or you might know from your own experience how efficient somebody is or should be, should be, sorry, not is, should be. And from that then you can work out what their billable hours are. So you can say, okay, I worked this out that in a year somebody should have, I think I did one recently on it was 1,760 hours in a year, which shall be billable to customers.
So once you work that number right, that’s your key number for your billable hours. Once you worked that out, then you can divide that into their costs, and their costing made up of their employee cost, and also any overhead costs you divided in. And that will give you a cost per hour for that employee. That’s a fully fully board and cost per hour for an employee. So you can work that out over all your employees so when you, when you have someone just being your employee cost, which is their salary, you also have the overhead costs built into that as well. And that’s how you can track that. So that gives you the really useful metric to have on are really telling you how much things are really costing, you know?
Interesting. So I understand that. And, and I guess the materials are most implistic in whatever it needs to get bought. You just raise purchase orders for whatever is getting bought and allocated to their project I get that. But then the overhead, so rent other expenses, you know like electricity, computers, it support our admin staff and stuff like that.So how do you, cause it’s not that everyone in the company is billing, so they go on their overhead, their staff cost needs to go onto overhead I guess. And then how do you, how do you split that up with monster projects. As some projects for last three months and some would be a month, some will be six months.
Yeah, that’s a very good point. So this, it comes back to key thing where you hear a lot of people saying you need to keep your overheads down. And really a lot of these overheads that help the business to run or work or whatever, but the don’t add any revenue. You know what you need to do is have the right balance between people who are earning revenue and overhead people, and overhead people might be supervisors or managers, are people who aren’t billable. Okay, so that’s point number one.
Point number two then is how do you charge it out? What you do is you take you out up all those overhead. See it that’s where you look at your budget, and you see a budget for the year. I know I’ve got three supervisors. Each supervisor earns 80 grand a year, fully costed for their salary and employer POC and everything. Then you work that, add that all up. Then you add in any rent and rates, light and heat, blah, blah, blah, the whole shabang. And you end up with, okay, my overhead costs for the year are 450,000. Then you say, how many employees do I have, and how billable hours are they actually allowed to, suppose to do in the year based on whatever efficiency rate I’ve worked out. I need divided the total number of hours into total overhead costs going out and do is give you that cost per hour on the overhead. And you might work that out. It might be five euros, it might 15 euros whatever it is, and you add that onto employee costs.
So I know that if I have an employee and he’s costing, he’s been a billable person. I know he’s costing me 60 grand per annum. I work out as already rate is 30 Euro per hour. And then I say I have to add on the overhead charges about 15 quid. So I really know that this person is costing 45 quid an hour for any work he does. So then suddenly that gives you a whole new insight into how to bellow, doesn’t it? Because you can see how many hours this fellow going to work in this project or many people are working this project. And the really cost, you can work all that out. I always see, I’m sure thinking there, well what if he does less hours, more hours? Or what if during the year you hire an order supervisor or you lose a supervisor or your rent and rates go up and all these costs change or whatever. Well that’s, we get these variances. So you need to, you can look at variances as well, but that’s a whole different ball game. It takes it, we can go through that in the earlier podcast maybe and just understand that for the moment. That’s what you’d work out and that’s how you’d be able to work out what your real cost are when you’re trying to work out how much to bill people for a particular project.
Very good. So those, that overhead cost is separate to the charging raise or do you combined the charging rate with that overhead cost? Or do you have a kind of a separate line their per hour?
Yeah, so the charge in rent is the employee costs plus the overhead.
Okay. So you do you combine the two there. Okay, I understand that. Okay. Very good. Very good. I hope our listeners found that useful. If you want to send in and listener questions, you can send an email to podcast on www.procurementexpress.com Garrett and myself are putting together a list of dozens of tips for improving your business, and improving, including cost accounting and project counting. You can get a free chapter on negotiation if you go to book.procurement express.com. But until then, we’ll see you next time. See you Garrett.
See you James.
All right, folks. There you have it. That wraps up our conversation with James Kennedy and Garrett Carragher. They shared a ton of valuable insights and advice today on how to determine the profitability of the projects your company works on. We also shared some tools and resources which will all be linked up in the show notes. Don’t forget to click on one of those links to get a free chapter of the book, Profit Leaks by James and Garrett. I hope you enjoyed our conversation. Please consider subscribing, sharing with a friend, or leaving us a review in your favorite podcast directory. Until next time, best of luck in all that you do. And we’ll look forward to seeing you on the next episode of The Gross Profit Podcast.