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Why Overhead should not be figured as a percentage.

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SJS,

 

Your last comment had particular relevance to me.  I was just talking about how difficult things are specifically because of the economy.  It seems like it's just a matter of scaling the expectations to the market that's left standing.

 

This overlooks a few details that make a big difference.

 

The recession in my part of the world has been going for about 5 years now.  Work went from plentiful to subsistence level in about 6 months.

 

All the remaining work is more competitive which has lowered profit margins.  Lots of honest old guy's retired or got pushed out of business at every level.

 

Lots of companies are on their way out of business bidding work at prices that won't cover their overhead.  This pushes the market value down, further suppressing the options for companies that aren't making that mistake.

 

Beyond all of that local stuff there are bigger trends.  Materials, fuels, rent, food, and taxes are all increasing while income stagnates.  Most of the folks competing in my market haven't seen a pay raise in half a decade.  It gets harder to put food on the table every year this goes on.  

 

On a personal level it's discouraging to see people sullying an honorable profession because they see shortcuts.  That's human nature at work.

 

I recently read an article about "lucky" people who were part of an experiment to see what made them different.  The gist of it came down to being observant.  Lucky people are more observant.  We attribute people's ability to act on opportunity to luck when we should be focusing on seeing the world like them.

 

The other half is doing something to act on what you see.  Getting overhead under control makes you lean and agile, aiming the business at real opportunities reduces competition, waiting for the right moment  to act reduces your risk and increases your odds of success.

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My sister is a designer, and my brother in law a general contractor, originally doing homes and apartment buildings... Lately some remodels and maintenance, though they just punched out one house and working on another. But she said the recession hit in September of 2006. They sold 2 houses on spec, and the 3rd spec house didn't get done till September and didn't sell for a year and they had to put 15-20k in upgrades and lower the price to move it before the real crash in 08...

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SJS

 

I'm sorry to hear things have been hard on your relatives.  Construction is a strange market, some areas will be hit harder than others and at different times.  During my apprenticeship it was common for job-sites to have a lot of traveling tradesman.  It was a tradition in some locals to give newly minted journeyman a US Atlas as a graduation gift.  

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Thanks to all and especially "rockstar" who seems to be a rare presence on the internet combining generosity, actual experience and articulation. There's great info here, but I expect I'm not the only one here looking for some small shop advice that is slightly different from what's been given so far. 

When it comes to bidding and overhead, how do you pros think about shop rates and billable hours? To put things in perspective, I've been earning my living as a blacksmith for almost twenty years, but mostly working for other folks. I took a stab at self-employment years ago, but I wasn't great at the business, partly from ignorance, partly from necessity. At any rate, I jumped at a day job that proposed to reward my most valuable skill set for once and chose it over barely making ends meet doing whatever came my way. Recently, a move for my wife's work and an assessment of the local market has compelled me (with much trepidation) back into self employment. Please don't take this as cocky, but the local market simply can't afford me as an employee, and there is a giant hole in the market relative to my most valuable skills (i.e. architectural forgings as opposed to fabrication) which could be good (have the market to myself) or bad (have to educate a clientele and build my own market.) In any case, I'm going to give it another go, and I'm trying to be much smarter and more conscious of running a business first and foremost.  

 

With all that in mind, I've been reading through this discussion and combining it with what's in the thread about bidding. It seems to me that small forging shops, are often in bidding positions less well defined than the competitive bidding situations presumed in the threads here. As often as not, my bid process begins with selling a potential client the idea that I can deliver something that they'll love living with, and ends with simplifying me design until I think I can meet their budget without going broke. Sometime it works, sometimes not. On the other hand, when it comes to overhead, more often than I am in a position to divide overhead between jobs, I'm thinking along lines like "I've got three, (or six, or twenty) weeks of work and the faster I can get it done, the faster I'll get paid", but I also need to cover expenses that aren't specifically billable to a client like marketing, networking, professional development, shop maintenance and the like. 

 

Relatedly, I expect that economists and business experts have real formulaic metrics to help indicate when capital investment is warranted. If anyone knows this stuff and is willing to share, I'd be grateful. What i'm thinking about is how to understand and structure capital investments in the shop as related to return on investment in the context of- and compared to- labor. That is, if a tool helps me do something faster, or adds to the capacity of the shop, when and under what circumstances is investment warranted? For an easy example, take a power hammer: it doesn't (at the scale of my work) do anything I can't do at the anvil, and it doesn't do everything I can do at the anvil, but it speeds the process so much that I can't imagine being competitive without one, so I have two. But if I think of how a hammer gets paid for, it isn't simply a matter of how much work it does that I get paid for, it seems like I should subtract from that the amount of work I could have done in the same time without the hammer. At the other end of the spectrum is a plasma cutter: I don't do much sheet work, I have a Beverly shear, and I'm pretty good with a torch so I've never been able to justify the expense of owning one. In the middle, (i.e. I really want a cold saw) it seems like there is a balance between the cost of any tool and how it effects productivity (a factor of labor), and I'm betting that somebody understands that balance in really useful ways. 

 

Grateful as always. 

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RE: ABOVE

 

As I look over what I just posted, I realize that those other expenses not specifically billable to clients are properly understood as components of overhead. Mostly I'm just trying to figure out how to stay above water while for a rough estimate, about a quarter of my time isn't billable. Maybe more as I start up. 

 

In the last paragraph what I'm looking for is a way to relate net productivity gains to costs over time. 

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Bird, 

 

I'm glad I've been able to help.  You have a lot of topics in there, I'll do my best to steer you in the right directions.

 

Sales, marketing, and bidding are all interdependent factors on the "pre-construction" side of a project cycle.  Getting the groundwork laid here is all about starting with the simple stuff.  

 

Work backwards, take a moment and define what annual profit level you want out of the business.  Don't forget to factor in growth and inflation. Add that sum to your overhead, and all your non-billable costs for a working year. Break that sum down by your estimated number of working hours in a year.  That gives you a baseline hourly rate that will only work if you're constantly busy.  If you know that work slows down a few weeks several times a year, you'd need to adjust the hours accordingly to "pay for the down time".

 

Business 101 types would tell you the billable should be roughly twice your hourly wage rate.  That's a VERY rough guideline.

 

So rough billable rate in hand, take a look at the market.  How many and how big are the jobs you expect to land per year?  When you're starting out, it's difficult to land substantially larger work so err on the side of smaller, more frequent jobs.

 

Based on client feedback, what's the "going rate" ?  Extrapolate the average duration and budget to see how that aligns with your projections thus far.  If you're too expensive, you'll need to find ways to offer better value to the client to close the deal.  Really often people focus on down-selling the project scope to land a deal rather than considering alternate means of production.

 

Working faster, more efficiently, or with less costly materials can often make a far greater impact on the client's perception of value than trimming their vision.

 

Since part of the billable rate is attributed to down time, you can focus your marketing on mitigating that.  I don't know the particulars of your venture but if you're normally doing ornamental iron, perhaps you could make lawn ornaments to sell to garden supply stores.  The idea is to capitalize on separate revenue streams that allow you some overlap.  Don't let it become a distraction or a cost center.  Wherever possible minimize investment and payment delay.  You can't afford a sideline that doesn't pay. When done right, it can substantially improve cash flow and serves to reduce the effective billable hour rate of your main operation.

 

If your billable rate is below the market value- you're either missing something or you're headed for a rousing success (isn't estimating fun!).  Bid at the market rate and watch the accounts.  If you missed something, figure it out and stay on track.

 

Production rates and capital investments are all hypothetical until you've tracked your operation.  Breaking the project down into separate processes will allow more precise feedback of where you're spending your time.  Don't forget that time spent estimating, designing, detailing, marketing, and answering questions are all part of the process.  Simple spreadsheets that give you areas to enter man-hours will show you where the time is being spent.  Time IS money.  Flat rates can cut a lot of estimating time out of your world.  Flexible mock-ups that can be re-used greatly cut down your labor on the next one. 

 

Any tool from a power hammer to a pencil will have some impact on your productivity.  Generally speaking the luxury of going faster is more expensive than working harder.  Economics professors love to boast that they drive old cars that they've paid good money to maintain well past the point most folks would move on.  Even factoring in the costs of increasingly frequent repairs, the old car is "worth more" than the near-instantaneous depreciation of a new car.  They're doing the math and it's really impressive just how bad an old car has to get before they'll invest in a replacement.

 

Your tooling question is really a Return On Investment (ROI) calculation.  What you'd do is take the gain from the investment minus the cost of the investment and divide the difference by the cost of the investment.  If the result is greater than 1, it will benefit your business, anything else is not worth doing.  Comparing the ROI between different options give insight into what's the better value.

 

Taking a power hammer for example, if it takes you 20 minutes to hand taper a rod and 5 minutes with a power hammer, you've increased your productivity by 400% for tapering rods.  If that was all you did, you could nearly quadruple your business by purchasing one.  It becomes obvious why production shops set up dedicated equipment for such items.

 

A more general purpose shop may not see such a speedy return on their investment since the tool might be waiting for projects.

 

A completely different take on this is related to opportunities.  If a piece of equipment allows you to pursue a viable income stream, the cost of losing that income is applied to the ROI calculation.  It can literally cost you money to NOT have a piece of critical equipment.  Lots of start-ups exploit the advantage by entering the market with state of the art equipment. 

 

It may sound robotic or cruel, but manpower can be applied the same way. Too many hands on deck is a costly scenario with sparse work.  Subcontracting out portions of the scope may well prove beneficial to your bottom line.  A lot of entrepreneurs get hung up on the idea that they must perform the entire scope of work themselves.  The client hired you to get the job done, sometimes that means knowing just who to call.

 

Again, it's important to maintain perspective.  The maximum you can afford to pay a subcontractor must be LESS than the cost of doing it yourself.  If it's not, you need to be addressing the root cause or adjust your bids accordingly.  

 

Let investments follow legitimate needs.  It's much easier to pay for a tool when you're constantly overwhelmed with work it would speed you through.  Sometimes folks encounter a "good deal" on a piece of equipment that's tangentially related to their business. Buying equipment and just hoping to find a use for it will drive up overhead.  Investing in tooling with a niche market use puts pressure on the business owners to pursue work that hasn't proven profitable.  Really big equipment is often heavily discounted for this reason.  Seriously ask yourself why the previous owner is taking a loss.  It may be because big stuff isn't as profitable to own.

 

Relating all of this back to your last question, it's a constant process.  Market conditions can fluctuate by seasons, years, decades or whatever.  To stay properly positioned in the target market, a business will need to regularly evaluate what's working and adjust accordingly.  The more flexible and diligent the business is, the better their odds of maintaining profitability over time. 

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Well when you put it like that, I guess I was asking a lot. Thanks again for taking the time to answer so thoroughly. I'm sure to be evaluating everything for ever, but so far, so good. Sort of. It's all hypothetical. I do have a plan for a complimentary retail-market sideline and I've worked up a rough estimates for shop rate. It seems reasonable and I'm trying to apply it to past projects to see if the calculated rate and price align. Hit and miss. Maybe I can do better moving forward. As far as the ROI calculations, I think I understand the calculations you're describing, but I was trying to factor in time. You could have an ROI calculation that yields a value greater than one but whose duration to achieve that value is very long and that might change how a person should understand a potential investment, but I think for now i'll stick with getting going. If I learn anything interesting I'll try to share it.

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Bird,

 

You nailed with the ROI issue.  You can calculate  ROI for anything that affects the business time, investment payback, profit, stress reduction, marketing expansion, etc.

 

To be truly useful, you'd need to use ROI as a tool from all the perspectives that matter to your operation.  Averaging their results gives you an indicator of confidence on the overall decision within your operation.

 

I calculate the ROI of my clients in terms of their annual profitability (to my firm), against their hit rate,  and bid workload.  

 

That tells me if a client who's running me ragged bidding all year is actually worth the hustle for the jobs they awarded.

 

Conversely, if can tell me that winning every job for a client isn't a good business move because we aren't making any profit on those projects.

 

Much more often that either case, it tells me that some clients know what they're good at and they're a great fit for my firm so we put up good numbers.  Companies that are all over the place are a risk to themselves and others.  Really often, I can tell which GC's are wasting everyone's time within a few bid cycles.

 

Getting back to your potential investment question, there are certainly examples where the ROI could go different ways on the same investment.

 

Forging something to shape is generally faster than milling it from a block.  It's cheaper in material cost's but higher in labor costs to forge the item.  Calculating the return on investment based on labor might be negative while the ROI based on material might be positive.  The average of those two balances their influence.

 

Now if you were commissioned to make something with great precision, in a difficult to forge material, the mill might come out positive.

 

If the mill were CNC controlled, you might be able to have it running autonomously part of the time - the opportunity to increase productivity may pivot the decision entirely provided you can put that to work in your operation continuously.

 

An ROI of 1 is "break-even" so if all your ROI calculations average to 1, you can see the pros and cons of moving ahead with the investment ranked by their severity (distance from 1).  

 

If you can come up with a mitigating measure to counteract some factor that's driving a negative ROI, you've found a way to make that investment pay off.  Also, you can see what would need to change for that investment to make sense.  In some cases that might mean waiting until business growth crosses some threshold before green-lighting that move.

 

Since this is just math, it works in both directions.  There will be thresholds in a downturn that signify it's time to sell off the ballast to keep the ship nimble.

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Right. So the basic formula that defines ROI is algebraic, but what seems more useful is the corresponding calculus that defines a curve which crosses (or fails to cross) 1 at some distance in time. 

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Bird,

 

The thing about statistics, calculus and math in general is that it's almost always possible to take it another step further.  Everyone must seek their own balance but I'd offer one significant caution.  If your reason for doing something becomes too complicated to quickly define; it's probably not a good decision.

 

If you did an ROI calculation based on your projected figures - follow up to make sure you're matching your projections.  You can do a lot but you can't go back in time.  Once you're committed, you'll have to find solutions to your problems.

 

I'd recommend tracking your business against milestones you set for yourself.  Keep in mind that some market's have seasonal ebbs and flows so a uniform projection isn't necessarily going to square with your actual performance even when things are going really well.

 

As you accumulate tracking information you'll be able to pick up patterns to adjust the next set of projections.

 

Use the projections as a way to define where you need to be according to your business needs.  Time spent "above the line" is what you're looking for.

 

You can build a spreadsheet that has three rows: projected, actual, and corrective. Corrective would be configured as an annual difference generator spread over the remaining time in the fiscal year.

 

Output to a graph over time on the X axis and what you'll see are three lines connecting their milestones.  If you have a good month, you'l see the corrective line "bending" downward.

 

As the year progresses, you'll have a better view of how things are likely to end up.  If you're seeing a steady shortfall between actual and projected, the corrective will grow exponentially because it compounds against the remaining time.

 

I hope that makes sense.

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