Figure 2. This hypothetical example for Joe’s Contracting shows how reducing the number of billable hours per year increases the cost of the owner’s salary per hour.
In the current economy we see more and more contractors losing money. It’s a no-brainer to cut your field force when you have nothing for them to do. Unfortunately, too many contractors mistakenly think that cutting field wages solves their cash problems. Reducing field employees obviously reduces cost but it also limits the potential dollars you can bill to your customers.
What many contractors fail to realize is the real issue is to reduce their overhead costs. Cutting overhead is painful. Rent and vehicle costs (leases or monthly vehicle payments) are fixed costs and little can be done to reduce these. A lease on commercial space is generally negotiated on a long-term basis and probably cannot be reduced until time of renewal. Your fixed vehicle costs will remain the same until you have paid off the vehicles or the lease expires. So where can you cut?
This leaves you as a business owner with few short-term options to reduce costs. The unfortunate solution is the only realistic way to reduce overhead is by reducing your office staff. This can be tough because many companies are family businesses with family and friends working in the office. Cutting the people who helped build your business also feels disloyal and unfair. However, the numbers may dictate no other choice.
Figure 1. This hypothetical example for ABC Contracting shows how hourly costs (cost per hour) fluctuate as the number of billable hours increase or decrease.
Let’s say ABC’s average field employee gives the company approximately 2,000 billable hours per year (40 hours per week multiplied by 50 weeks worked per year), assuming in this economy no one is working overtime. Let’s say that ABC Contracting had 25 field workers that generated 50,000 billable hours (25 field employees X 2,000 billable hours per man = 50,000 billable hours per year). With the economy slowing, ABC’s sales have dropped, and they had to let 10 field employees go, cutting the number of field employees to 15. This also means billable hours have dropped to 30,000 billable hours (15 field employees X 2,000 billable hours = 30,000 billable hours per year).
We will also assume ABC’s overhead is $800,000 and the company’s average field wage, with labor burden, is $20 per hour. While ABC Contracting reduced the number of employees by 10, their overhead costs have remained constant at $800,000 per year. This means their overhead cost per hour has dramatically increased. With 25 field employees ABC had an hourly overhead cost of $16 ($800,000 ÷ 50,000 billable hours = $16.00 per hour). With 15 field employees ABC’s overhead cost per hour grows to $26.67 ($800,000 ÷ 30,000 billable hours = $26.67 per hour).
Overhead recovery is a direct result of how many employees or hours you have working in the field. The chart in Figure 1 illustrates how ABC’s hourly cost fluctuates as hours increase or decrease.
If ABC bills their customers at $40 per hour for labor and estimates are correct, with 25 field workers, ABC made $4 per hour net profit on their labor ($40 billed labor - $36 cost per hour = $4 net profit). With 15 field workers, the company is losing $6.67 per hour ($40 billed labor - $46.67 cost per hour = -$6.67). By cutting field production by 10 employees, ABC’s overhead increases a whopping $10.67 per hour. What used to be a winning job is now a loser.
The simple truth is, if ABC does not reduce its overhead costs, they will cease to exist. With 25 employees the company made $200,000 profit ($4 net profit X 50,000 billable hours). Now that ABC has 15 employees they will show a $200,100 loss on labor ($6.67 loss X 30,000 billable hours). Suppose ABC cuts field wages by 10 percent or improves production rates 10 percent; that only comes to $2 per hour in savings and they still lose $4.67 per hour. Labor cuts or production increases alone will not save them.
For small contractors the situation is a bit different, but the principle remains the same. Let’s see what Joe, with a five-person shop, might encounter. In 2008, Joe employed five field employees, a part-time office manager, and himself. Due to the decrease in business, Joe had to let two field employees go.
Joe had structured his company so that his compensation, salary and benefits were $75,000 per year. Joe needs to make this per year to cover his personal bills. Unlike ABC Contracting, Joe is unable to reduce his overhead by cutting office employees. Joe’s own salary is the largest overhead expense.
We can use similar calculations for Joe’s Contracting, illustrated in Figure 2. Instead of using total overhead we will plug in Joe’s yearly compensation.
Joe’s compensation has gone from costing the company $7.50 per hour with five employees to $12.50 per hour with three employees, an increase of $5 per hour. Since Joe’s salary is the largest overhead item, he has to move some of that cost back into production or take a dramatic salary decrease.
Though it may be natural for contractors to cut field employees when business slows down, remember that potential revenue also reduces. If you do not make cuts in overhead, your business will end up underwater. Making cuts is painful, but the math is clear. It is better for some employees to lose their jobs than the company to shut its doors. We realize making such cuts takes time, but you cannot escape reality. Two plus two is four, and no matter how hard you try, it won’t turn into five. If volume remains low, the only way to save your business is to cut overhead.
