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Why Overhead should not be figured as a percentage.

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Don't get trapped

There are quite a few traps that people fall into when it comes to overhead and profit.  Perhaps it comes from a desire to simplify operations or a lack of follow through but one thing is certain: percentage based overhead calculations aren't accurate most of the time.  It's possible that a given percentage on a given project will end up covering the overhead costs for that project's duration.  It's just unlikely.

Overhead is not optional, imaginary, or driven by profit

Lets start with the nuts and bolts of overhead.  These are the costs of doing business.  Everything from office rent to printer paper get's paid out of overhead.  Depending on how a company is structured, overhead may also pay the wages of staff members.  With rare exceptions, overhead costs are predictable and occur at regular intervals.

hitman-monkey19.jpg?w=300

Like ammunition for example...

 

The key element I'd like to call attention to is that overhead must be paid as a function of time.  Rent will come due every month - it has nothing to do with how well the jobs are going.  As a bare-bones issue, overhead is a non-negotiable sum you must be earning at all times or you're losing money.  Even non-profit companies MUST make overhead or they'll go under.

Getting a handle on it

Figuring out overhead isn't complicated, nor does it need to be.  I recommend taking the entire years worth of overhead costs (or projections) because some items are only payable annually.  For example a subscription to a trade publication, or the renewal fee for a license.  For companies with several years of records, I would encourage you to calculate the years separately to see year to year differences.  We're looking to establish a baseline, not split hairs.

So annual costs (or projections) in hand it's time to add for inflation and growth.  For the sake of simplicity let's say that in an improving and expanding market, a 5% add is in order.  For a depressed market, it could be lower.  Unless you've got great reason to do so, don't go negative.  Take this annual figure and divide by twelve for monthly overhead. Divide the total overhead by 52 for weekly.  Take your weekly and divide by five for working days.

Notice how I didn't take the annual and divide by 365 to get days?  Working weekends isn't typical for most businesses.  There are 260 working days (no holidays) in a year.  One way to handle the holidays is to assume 50 working weeks per year which give 252 working days per year.  The goal is to shift the overhead costs onto the working days.

Each job pays its own way

Now that we've got the daily overhead rate we need to answer some job specific questions.  First off, how many jobs will be going at the same time?  Each job needs to carry its fair share of the load.  Looking at company history to see what the average concurrent job count is will prove helpful here.  If there's reason to believe you'll have four projects going at all times, the overhead rate applied to each job should be a quarter of the total.  I call this office commitment. Be warned that each job is different.  If you're looking at a very large job, it could consume all the companies resources for its duration.  Similarly, a "hurry up" job that requires you to drop everything would affect its bearing on your overhead.  You will quickly see that faster is cheaper.  A notoriously disorganized client, architect, or owner should indicate that a higher portion of your overhead costs will be attributed here.

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Pictured above: A typical Owner, Architect, Contractor meeting.

Delayed gratification (and payment)

So are we done?  In a word, no.  The sad fact of the matter is that work is nearly never paid for as quickly as it's done.  A standard practice in the construction industry is to withhold payment equaling 10% of contract value until the project is complete. A heavy equipment contractor would obviously complete their work well before a building is completed.  That contractor may not see full payment for several months!  Any financing costs arising out of their need to cover bills while awaiting final payment must be paid out of overhead which can be factored by the actual delay in getting paid.  Running a quick scenario, imagine it takes two weeks for that heavy equipment contractor to do a job and there's about $1,000 a week in overhead for the operation.  If it takes sixteen weeks to get the last 10%  then $200 worth of the overhead is accruing interest for four months.  Let's say it's a credit card interest level of 15% which makes the additional cost $30 for the first month, $34.50 for the second month, $39.75 for the third month, and $45.64 for the last month.  Because it's compounding, that delay ended up costing $149.89 to the contractor even if they got on to other projects while awaiting payment.

Taking stock of all these factors, you will arrive at a total overhead cost.  The overhead is not driven by how many people are working on site because those folks are job-billable.  The overhead is not driven by project cost because again, all of that is job billable.  Project duration, inflation, payout delay and office commitment are the only factors driving overhead.

Unintended consequences

Getting back to the headline of this article, I'd like to illustrate why percentile overhead calculations are so ruinous.  First off they work on the assumption that all jobs will consume overhead proportional to project cost.  This has the effect of charging too much overhead for jobs you're really efficient at, and charging too little overhead for jobs you're not as efficient at.  By extension this causes bids to run higher on jobs that more perfectly align with the companies abilities.  Conversely this causes bids to run lower on jobs that don't align as well.

Let's say we're a company that furnishes and installs millwork.  There are two jobs to install millwork in commercial spaces.  One job specifies more expensive laminate material than the other but every other factor is the same.  Does it make sense therefore to bid a higher overhead amount for the nicer laminate?  Jobs are often won and lost by such amounts.  A set overhead percentage will only fit one dollar value perfectly.  Everything else is a bet against the future that you'll pay for in lost overhead, or lost jobs.

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I am a blacksmith, not an accountant.     Thus is the reason why I am destined to wear old boots to my destitute grave.      My all in operating costs were $186,000 for 2013 which was just about ten grand more than my gross income.   At least the govenment made money off my labor.  (Sales tax, B&O tax, Personal property tax, Property tax and so on.)

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The jump from the two pocket hobby (seed money in one and sold product money in the other) is a far cry from business.

There are some on this list who run multi employee businesses as a forge shop and I both envy and shed a tear from them. I liked my time working in a group on large projects, but also like the solace of my one-man operation on more easy to manage projects.cliental

 

I do a huge amount of R&D on steel and techniques and tooling which deeply cuts into "profit" as most of the time it a sucking hole. I reagin some of that with unique product from that R&D and also teaching the odd techniques to those who care to spend a week here in the shop.

The insurance for teaching and mental burden of keeping four-six folk safe in the shop is a drain from the pocket and the sanity. So far it has proofed out well.

 

I live and work on the same property. For ten years I ran the business while being Mr. Mom..now the boys are in school so I get my days..well, most of them anyway. I'd like to say that I time all the work well and do office stuff during down time and all runs smoothly, but this is simply a illusion. Daylight is time for office calls, forge work and answering emails from a cliental which expects immediate responses..the younger crowd at least. 

 

I have dropped architectural work almost entirely...well architectural work has more or less dropped me since construction in my area is down and few call for ironwork. I am focusing on all that I can do and after a year or so do an analysis of where the best direction/profit is and the focus on offshoots of that.

 

I encourage smiths to get a product line so they can get efficient at a "thing" and be known for a "thing" and then do the other work which comes from being "known". Trying to be a jack-of-all is a sure way to be really good at nothing.

Also...overhead may be ten times for you what it is for me...that is driven by many factors...location the most likely.

Keep track of major and minor items you use. Buy in bulk for sales if you can, keep a limited inventory as it is taxed, have a good accountant and sit with them at least twice a year, PAY YOUR TAXES, FIND OUT WHAT TAXES YOU HAVE TO PAY so an odd one does not jump out later.

Charge for your work....all of it.

 

Ric

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Forgot

 

Take care of your body...joint pain and chest pain and "being a man bout it" will work you out of the ability to do work. Hoists, roller carts, pivot supports, power tools, smart use of jigs and swages will save you time and wear on your body (and your work may even be better for the use).

I am very tool dependent..larger power hammers (all relative of course), presses, swages, jigs etc. Wait for the steel to be hot as it is more superplastic and the yield strength decreases with heat...so it moves easier. Many things one CAN do in one heat, but the last 20 power hammer blows or ten hand hammer blows are less effective then grabbing the next bar that is hot...so I stick it back in and let it wait its next turn.

Small number of heats is important for efficiency, but if you are using tooling you are already more efficient so do what is easier on your body....there are usually very few replacement parts for your flesh, but an endless supply of tools...yes even honored and hallowed anvils and power hammers are replaceable, nay consumable, tools.

 

off the soap box.

 

Ric

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All the above makes sense(except that Larry forgot to mention that he got some nice toys/tools that year) and rockstar you obviously put in a lot of effort to put that together yet for those that need an idea of how to 'do it' well , as the song goes "there are more questions than answers "

Sometimes I think in has to be as scientific as ...ER... cost of materials, times 2.4 plus and add a bit....maybe one months school fees, or was that one term ....., hang on maybe it should be less? Now was I pricing that in Pounds English or Egyptian? Dirhams or Dinar ????? Aw stuff it $4 500.00 seems right(but I'll bid $4 520 as it seems more precise). Sadly it's often done 'this' way, and mostly undercharged and the workload underestimated. Quite a few smiths I've met over the years seem to do it this way(few admit to it though, not even to themselves) some seem to have done well for themselves despite this unscientific format. I wish I had 'The Formula' to share but sadly I don't!

BTW if $4 500 seems right it probably should be at least 20% more!

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Actually Ian Its been several years since I have been able to buy any new machinery.  I really am losing money.  Its been 4 years since I turned a profit and I am not far off from closing the doors.    I am pretty burned out on working 3-4 thousand hours a year only to be worse off than the year before.

 

Its the overhead that is killing me.  Around $12,000 a year in insurance,   $30,000 a year for a lease,  $8000.00 in fuel  $25,000 a year for the government,  it goes on and on.    At the end of the year there is nothing left for me except stress

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Larry,

You are not alone in that boat. I had the luck of working for a shop in Florida where I went Hobby to paid employee for three years. I probably cost them money the first six months to maybe a year....last year there they made up and then some. Mostly due to the work contracted, but some to my increase in skills.

 

When I opened under my own sign it was nothing for the first five years of note and only recently...some 24 years into the craft.... that I have seen some light.

I keep overhead very low and rarely get into work I can not do...though scheduling is always an issue getting work out on time.

 

Maybe its time to seek a new area with home/work on the same land and develop a product line less diverse than your current work. This would cut insurance and lease down to your current fuel costs and running natural gas has chopped my fuel bill by loads vs propane. 

I would think a change of region could cut set costs by 70%....can you take any clientele or product with you in a move or is it strictly regional in business?

You could move down the street me.....I would not mind.

 

As to the stress....can't help much there. Seems to come when uninvited.

3k hours a year is high for not much in return save stress.

 

I'm sure Ian has some wisdom to impart....he has been through it all and has a keen mind.

I suggest sitting down with financial advisor, small business mentor or a good friend who will bounce the truth back to you.

Some metaphorical burials are dumped on us and others have us holding the shovel....either way getting out from under it is the goal.

 

Ric

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Ric I am kind of stuck.   If I was able to just downsize and move I would have done so already.    I have plans to move to rural Idaho, where I grew up,  but it will be many years before that can happen.      Real estate prices here pretty much rules out me buying a place with a shop I can work out of.    I have looked for years and once in a great while something turns up that seems suitable but I can never seem to swing a deal.    On top of that the bank wont give me a mortgage.     They don’t care what your cash flow is, only now much money you made, which if you add up the profit from last 5 years the number has a minus sign in front of it.     I can’t move from the area yet because we take care of my wife’s mother who is blind and has a routine here that makes her life livable.    She is too old to force into a new location.    I have tried to convince my wife that we could mover her with us but she says not gonna happen.         I cant even “downsize” really because the cost of moving and setting back up would nix years worth of rent savings.        I have really struggled mentally with what to do.    Of course the shop pays for a lot of things that would come out of pocket if I had a wage slave job so its not like I have nothing to show for working but It still is hard to get excited about taking on work that you know in the end the money will all be eaten up by expences.   

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Sounds a bit brutal Larry...sorry to hear.

 

Moving does have a large cost with large tooling...and a not too small cost otherwise.

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Greetings Ric /others,

 

The bottom line is YES.  You should include your overhead in your price for your services...  In other service industries it is common practice to include overhead in the cost ..  Doctors, Lawyers, Auto service, all have an hourly rate and most require a payment before service is rendered..  Unfortunately I feel the demand for hand built quality iron work is diminishing with the availability of ready made products and overseas influence .  I operated a modestly successful blacksmith shop for 15 years but I had 30 years previous business experience .  I attribute my success to being very diversified and offered a wide variety of products and services...  I built a complete portable welding trailer and attempted to offer on sight repairs and fabrication of older iron work..  What a flop.. Cost me 10k ..  Positive thinking , cost control, and an open mind for new business is the only answer..  I am retired now and am quite content just teaching new and advanced students some of what I have learned it the past 45 years of business..  I wish you all well..

 

Forge on and make beautiful things

Jim

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Larry, I'm sorry to hear that things ain't going too well financially & I hope they get better. Ric I have visited Larry in the past and he has an awesome setup with oodles of kit, you could possibly 'hide' you shop amongst his stuff.

Larry, often things become a state of mind and that mindset becomes your reality. I had started to build a new shop of about 4500sqft next to my house some years ago, I was using 2nd hand bricks and roof sheeting etc. Just plodding along as and when. I'd stopped operating my Johannesburg shop but just paid the rent to store my stuff (cause it was easy) then in December last year the landlord sold the place for redevelopment and I had to get my kit out in less than a month. December here is shutdown month and everyone closes on the 7th, my 10ton truck had been stolen so I just 'made a plan' I got finished(after a fashion) and moved. Its not fully finished its very crowded but I'm in!

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Sorry to hear things are not working out well Larry.  Have you considered throwing a wall up and dividing your shop in half and renting out the other half of the shop?  I  am considering buying a second neighbouring building but I will need additional income to offset the mortgage and additional property taxes.    The second building is larger than my existing building and I am considering doing this as one of my options.  Another of the options is to do some wharehousing in half of the shop.   I know you are used to all the space you have but if reducing your space could save your business maybe it would be worth it.  If you cannot find a smaller shop space surely others are having a similar problem. 

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After 7 years of running my own business I grown tired of chasing work, dealing with picky home owners, contractors who want it tomorrow, who also found a better price and want you to cut yours, and the over head. In my case has been very low as I work from a home base business with no employees. So this year I decided to shake things up a bit, let my business set and go to work for someone else for 6 months and think about it. I am working as a blacksmith, historical interpreter but the pay is little better than minimum wage and seasonal. Love the job though, but it is 40 hrs a week so I miss the freedom being self-employed. Looking ahead I am planing on starting a product line like Ric has suggested and see where this leads me. Also thinking about moving my business base to Northern MI to lower my overall overhead costs. I have watch Larry business for several years now and have been empressed by what he has accomplished but his overhead is staggering. His tong line seems to be doing well which goes back to a product line theory. One could look at Grant Sarver's business model and come to the same conclusion. I have another friend who has a internet based business and product line but has grown to the point where he is having growing pains. Lots to think about in your business plans.

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Monstermetal,  I'm sorry to hear things are so tough, I really wish I had an easy answer to fix everything.  You've already identified the cause of your problem.  If the overhead is higher than your competitors, you'll either lose work or lose profit when you drop prices to a competitive level.  I'm afraid that neither option is sustainable.  

 

I encourage you to be optimistic, flexible, and committed to making every move count.  Many firms "ride out" a market downturn by cutting to bare minimum to technically stay in business without enduring the overhead of the running concern.  This puts them in a better financial position to capitalize when the market bounces back.  If they took on debt to keep the doors open waiting on the market rebound, they would have that additional overhead consuming the profits when the recession ended. 

 

Taking some time with the family and working for a set wage  (with low stress) could give you safe harbor till the market improves.  I hope everything works out for you, it's certainly a tough situation to be in.

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Sounds great in theory but does not work so much in practice.     I have several hundred tons of equipment and material,  A 6600 sq foot building crammed full of several hundred thousand dollars’ worth of equipment       The only way I could take on a regular job would be to have an auction and liquidate everything,  which I have considered.     It would mean assuming huge losses on inventory and machines that most likely could never be replaced.   I have around $40,000 worth of steel inventory that would likely bring a few grand at auction.       I have three 40’ containers full of parts and equipment and a half acre yard stacked 15 feet deep.      Just closing up and going to work for someone is not really an option.           I have thought a lot about what to do and the answer always seems to be just to keep doing what is in front of me.   Its my own fault.    If I would have stayed small and agile Id be in a whole lot better shape but when times were good I just kept buying equipment and expanding.   My gross is now about 60% of what it was in 2008 but my overhead costs are up by 20%.       There is no simple answer  :(      If someone would offer me a GOOD job (something making 75 grand a year or better that was fun and had a future)  I probably would simply call the auction folks and call it quits.

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Greetings Larry,

 

I am sorry to hear of your business problems... I have been there and done that...  I had a very profitable business for a long time and had 9 employees .  As my business increased I would add personal but the profit went down.. The additional volume of business was not the answer.  All I did was add more expenses to keep up to the increased business... I made adjustments and controlled expenses and returned to profitability.  I would suggest scaling down, selling unneeded equipment, making as much equipment mobile  as I could so that you could move it to a portion of the shop that does not require as much heat.. I found when times are hard you have a tendency to take on less profitable jobs to keep volume up..  Scaling down , raise your prices , only take on profitable work . Just my 2c .. I hope this helps..

 

Forge on and make beautiful things

Jim

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Larry, those of us who were self-employed and owned our own business know what an economic downturn is like. Hang in there, brother, and get some advise from the Small Business center in your area. 

 

You will get less money per item if forced into a distress sale, if you even get any after the creditors. Plus there is the personal anguish of the process.  For most of us, selling off tools is akin to selling blood. But when the IRS or Sheriff padlocks your doors, you have already lost control. Better to thin out the stockpiles by attrition, and sell off one piece at a time, while you are still in control.

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Monster, whatever you do won't be painless.  I really wish I could say otherwise.  I genuinely thought of advising what Jim Coke said he did which is to cut overhead, raise prices, and chase only profitable work.  That's a fine answer provided there's actually a market to support you at that price point.  It's hard to accept, but the market is bigger than all of us which means we're forced into tough decisions.

 

Just last night someone asked me if I wanted to strike out on my own.  The fact is that even with a long list of contacts and a history of winning competitive bids in my local market, I still strongly advise against a new venture right now.  The market is so tight right now that getting up and running is simply too costly to expect any return from the business for five years or more.  Considering that only 5% of start-ups in construction make it to two years in good times, it's an unacceptable risk for all involved.  By waiting I'm allowing the standing firms to take the brunt of the downturn.  When the market returns, those remaining firms will be in recovery which helps to even the odds for a start-up.

 

John McPherson's made a solid point - you have latitude to make changes right now but continued losses will close doors progressively.  You could look at shedding overhead as a means to buy your freedom.  There's a logical misconception called "sunk cost fallacy" where a person gets to thinking that they've already put so much money into something that they feel the only way to "keep their investment" is to keep whatever's costing them money.  Don't fool yourself, if you have a tool that's not paying it's way, it's costing you the opportunity to earn a better return on your investment.  Just like an employee that's not pulling their weight, it's critical to look at equipment investments in terms of their impact on your profitability.  

 

The tools and equipment you've accumulated appear irreplaceable to you now.  The fact is that you found them when you could afford them then, and you'll have those abilities when that time comes again. We often overlook the potential for better options to greet us in the future.  I can tell you that having a profitable business and money in the bank makes it a LOT easier to strike bargains on excellent investments.

 

It may be helpful to focus on the idea that you built a business, not a shop.  Protecting and nurturing the business is what cultivates opportunities to do great things.  I think your signature line is an excellent quote that has much relevance here.  You can build a big operation with wind in your sails, that's solid.  Now while there's a calm, it's time to knock off the barnacles, offload the ballast, and patch the sails.  I really wish you the best.

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I have a small machine shop and I make my own products,   I joke that my shop is ground hog day the movie. I make the same things everyday. I am very good at it and efficient. I used to be in my garage and I couldnt grow any bigger which meant I was only going to make 15 bucks an hour forever. I rented a shop for 1500 a month plus utilities and my business grew alot in the first year out of the garage. I bought a building with a blacksmith friend of mine and now my overhead is very very low and it has changed my life. Having low overhead allows me to hire people, I am lucky in that I live in a town with low realistate costs compared to seattle. I was at larrys shop and it is pretty sweet. there is a price to pay for low overhead, I cant sell anything in my own town because people are dead XXX broke. I ship world wide and in the past 5 years I have sold less than 1500 dollars in Tucson. I have sold at least 20 grand worth of stuff into seattle.

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Larry, my Dad closed his office in a high-rent high-rise after he had been in business for a decade and had gotten his name out there. Converted his two car garage into an office, sold off all the excess furniture, hired only family and parked his Caddy in the rain. Best move towards profitability he ever made, stayed solidly in the black for two decades and a couple of business cycles until he retired. Best of all, it allows you to turn down work (and/or clients) that is questionable or unpalatable.

 

You can only work so many machines at a time by yourself, or with a skeleton crew. Selling a portion of the excess machines to pay for the move may be the way to go. In the end, it's only stuff. It can't love you back.

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Not a percentage, but overhead should be in proportion to your market, right? Obviously the lower the overhead the more profit, more profit, more growth, more overhead, what then? Better your market! Where is your best potential for income? I think that is the larger question than overhead... Having been in the architectural business for over 20 years I have seen glory and destitution. I then sought out work that is fulfilling but without much profit, so my overhead had to decrease to very little. I have been patient and spent many hours of research to find my market, one I feel has the most potential for profit and fulfillment. 

 

Having one the largest and best equipped shops, one would hope to have the larger a more demanding jobs to support it.  Larry, I think you are one of the most creative and hard working smiths I have met. Following your work I have had a hard time understanding why other work besides industrial smithing has not been more accessible? It seems any large metro should have many jobs in entertainment and restaurant business- props, interiors, signage, sculpture, fountains, cars, motorcycles, etc. Maybe the market in Seattle is flooded with artisans as well? I can defiantly see your shop as a premiere artisans studio where anything could be possible and profitable! I really am pulling for you as well as the rest of your friends here are, we all wish you success.

 

Michael

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Dillon,

 

I think the problem with proportional thinking as it applies to overhead is that it conceals what your prices should be.

 

Many people figure that competing firms are running roughly the same proportions.  That is to say that they have roughly the same overhead, profit, wage rates, productivity, and so on.

 

This is absolutely wrong.  The reason the competing firms have similar prices is because the competitive market is setting the price.  Some competitors will bid what the market will bear and hope for the best.  Some firms will price themselves out of the market. Some firms will under-price the work at their peril if they can't perform.  Pricing overhead as a percentage of project value is shamefully common.

 

If you have a firm with higher overhead than your competitors you may still compete provided you can offset that disadvantage in other ways.  I specifically link overhead to TIME and burden.  So you can either do your work faster, or you can have more jobs concurrently under way to spread the overhead across them all.

 

That's a fine answer provided it's possible to find jobs that will let you get in and out quickly, to say nothing about the difficulty of landing exponentially more work than your competition in a recession.

 

I think you're absolutely correct that the often overlooked answer is to start by defining what your target market is, then build the firm to maximize value to the client and profitability for you.  Unless you're especially clever, it's hard to keep a cap on news of a gold-mine.  Eventually you'll have to defend your turf by being the best value while still being profitable.

 

Unfortunately most markets are subject to economic trends that mightily test the firms trying to get through the hard times.  Running a profitable enterprise while your market is in recession is a substantial accomplishment.

 

We often hear accolades about companies growing.  Without question, the lions share of overhead imbalance occurs when successful firms try to grow when times are good.  It's tough to put tomorrow's overhead into today's market pricing and land work before you grow.  Lots of profit gets lost "ramping up" to the new level because the jobs are not fully funding the overhead commitment. The construction market is particularly likely to have companies that start with a boom and boast 5-10% continuous growth until the day they lay everyone off.  This pattern contributes to the feast or famine nature of the construction market.

 

Starting and running a business is very challenging, entrepreneurs certainly get my respect.

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Figuring out how to cheap is an art, its like buying a used car.

Some people have mastered it,

Exxon moblie made a 8.8% profit last year
Total revenue was 448 billion dollars,


A business should never own anything that doesn't make it money, some are investments.

If your paying to store things, spending your time organizing them ect (we all are).
Hiring people won't help you if the work your doing doesn't earn a dime.

It's pretty impossible to forsee everything, even if you do everything right your still going to lose money while working.

Just do your best, make sure you take care of yourself, motivation comes easily with good health in the body and mind.

The key is to remember why things are hard and its usually because your life has changed, perhaps you have tried to stay the same when its no longer an option and you are forced to change. It's evolution, it never stops, its happened before and Will happen again.
The problems will change and so will the solutions, it only increases your abilities.

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for some comic relief here is a joke...

 

What's the difference between a farrier and a blacksmith???

 

Cash flow, people like art and horses, but they don't need art, but they do need their horses trimmed and or shod...

 

I have been smithing for 30 years, and been a full time farrier for 20. I would love to be able to make enough to support my family with smithing, and 15 years ago the 10 year plan was for me to be out from under horses and in the shop:-) oh well, maybe as a retirement business, when I cant get under a horse anymore.

 

But I am going to still try to develop a product line, that I can make profitably, and maybe I can make a go of it...

 

I will pray for you Larry, you are really good at what you do, and surely there is a way to turn things around even without the economy roaring back to life...

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