Lost in Translation - Cost Rates

Have you ever been in a meeting and halfway through felt like you were going to be sick? You learned that something you have been doing for a very long time wasn’t accurate and was causing you to make decisions on misinformation. We recently had this very conversation with a client, however by the time the meeting was over, that sick feeling had vanished, and the business was moving forward with accurate information that will drive better business decisions. So, what exactly happened?

During this meeting with our client, we were discussing the estimation process and how the business came up with their estimates and the rates used in the estimates. For the past couple of months in meeting with this client, we were struggling reconciling the financial results of the business with the net income margins the business owner was saying their projects generated. The financial statements showed a net income margin of between 7-10%consistently month after month, however, the projects estimated a net margin of around 22%.

Was there an efficiency problem and the hours worked on a project exceeded the estimate on a consistent basis? Was there an issue with the estimate and not all the work that was required to be done being captured in the estimate? As we continued to ask questions and dive deeper, it was determined the main cause of the difference was due to the fact the business didn’t understand what their fully loaded cost rate was.

The business thought the rate they were using of $50 per hour was the fully loaded cost rate to cover the cost of their operations labor along with all the overhead of the business. The actual fully loaded cost rate is $62 per hour. There were costs not being accounted for by the business in their rate. This explained everything and now the financial results made sense. Something as simple as the cost rate was causing the variance between what the financial statements were telling us and what the projected net income margins were showing.

At first, there was a look of shock on the business owners’ face when learning what was happening. Instead of thinking they were making 22%net income margins on a project they were really only making a 7% net income margin.

After processing the information, it did make sense to him and further explained why he didn’t think the business ever had enough cash in their accounts or as much as he thought there should be.

Although this was not the answer the business owner was looking for, the business owner now had a clear understanding of how the business was performing and the sickness in his stomach started to ease. There might be projects that before the business would take on, but now may steer away from because they know they will lose money on the project or only take them on if there is excess labor capacity. They now also have a plan in place to look at opportunities to increase their billing rate or cut the excess overhead cost to improve their net margin.

This example shows how important it is to have accurate information when making business decisions. This small business isn’t alone, we see many businesses that make decisions based on information that isn’t accurate or sometimes no information at all. This leads many businesses wondering why the actual results of the business do not line up with what they think should be happening and cause frustration and a feeling of constant defeat.

If you feel like you or your business is in a similar place and you would like to discuss, feel free to reach out to any of us at MackeyAdvisors (859) 331-7755.