Are Indirect Labor Costs Killing Your Cost Competitiveness?

Despite being similar in dozens of ways and having many lessons we could learn from them, contractors rarely look towards the manufacturing industry for tips on how to run their operations more effectively.  That's a real shame.

Prior to 2000, nearly every business improvement practice introduced to the business world came from the manufacturing industry. Some examples are: breaking jobs into specialized tasks, statistical process improvement, cost accounting, incentive pay, self directed work teams, safety standards, standardized operating procedures, and customer centric business planning.

What has always caught my eye is how similar construction is to manufacturing, and specifically to a manufacturing job shop. In a job shop, each item is built to a specific drawing, the product is generally not mass produced on an assembly line, and controlling productivity is a never-ending cause. The same can be said about construction projects.

Today, we're going to take a practice from the manufacturing world and adapt it to our world. Manufacturers are obsessed with one piece of information that contractors across-the-board are almost oblivious to: indirect labor.

Are you familiar with the term Indirect Labor?
Indirect labor has a profound impact on your cost competitiveness and your bottom line. Indirect labor is something you need to keep a close eye on and manage aggressively.

Let's start with Encarta's definition, I'll tweak it to better represent the accepted meaning in the manufacturing world, then I'll explain how it should be used in your business.

Per Encarta's online dictionary, Indirect Labor is:
Work not directly related to production: work that is not considered in determining costs per unit in producing or manufacturing something, e.g. work done by clerical or maintenance staff.

In the manufacturing world, accounting usually draws the line between direct labor and indirect labor based on job position. In other words, all hours turned in by factory floor workers are defined as direct labor hours. Hours turned in by everyone else are considered indirect labor.

When it comes to indirect labor, manufacturing can get away with tagging positions as either direct or indirect. It makes the cost accounting easier and it rarely sends misleading signals to management.

That approach does not work so well for contractors. Where manufacturers can cleanly tag a particular job as either direct or indirect, you as a contractor must look at each field worker hour. For you, indirect labor should be coded by task, not by job. Failure to do so can mask a potentially devastating expense.

Both Guy and I have seen this over and over - a contractor's casual approach to timesheet coding covers up a significant amount of wasted time.

The wasted time is created by poor labor coordination and decision making on daily assignments. Many times, the field productivity is far better than indicated as hours that should be coded to indirect activities - and pulled out of the labor productivity calculation - get tossed into the pile of direct hours and used to measure field productivity.  That is an extremely misleading practice.

Wondering whether you have an indirect labor opportunity to capitalize on?

Here's a quick acid test:

  1. Do your field workers code their time to a project?
  2. If the answer to No. 1 is yes, do they assign their time to task codes?
  3. If the answer to No. 2 is yes, do you have a task code for "overhead" or something similar?

If you didn't answer YES to all three, you could not possibly know the amount of time and money you're losing to indirect labor. You need to correct that situation as soon as possible.

If you truthfully answered YES to all three, congratulations.  You're probably in pretty good shape - assuming you taught your foremen and/or superintendents how to code time.

Be forewarned that your indirect labor should not be zero. Zero is neither a realistic nor desirable target. The appropriate amount of indirect labor is somewhere between 1% and 10% depending on the size of your company and the service it performs.

Large contractors should be no more than 5%, and preferably well less. Smaller contractors, especially those whose average job runs less than two weeks, are probably in the right neighborhood if their indirect labor runs in the 5% to 10% range.

Common tasks that should be tracked and treated as indirect labor are:

  •   On-the-clock drive time
  •   Planning and coordinating
  •   Meetings
  •   Equipment maintenance
  •   Preparation in the yard prior to heading to the job
  •   Paperwork
  •   Working around the yard and shop
  •   Waiting on and handling material or equipment deliveries

(The last item should be eliminated by planning, coordination, and communication.)

You might be wondering how bad your indirect labor could be. All we can share is what we've uncovered at some of clients' businesses after getting the proper tracking system in place.

30% - that's right - 30% of their field time was spent not putting in work.

To throw gasoline on that fire, their 30% did not include the cost of working inefficiently or lazily. Those are completely different issues and costs. And they went on top of the 30%.

The 30% we found were hours the crews assigned to indirect labor tasks. Even if 10% was a perfectly appropriate number for these contractors - and in some cases it was - that still meant one out of every five hours was wasted.

Imagine how much more money you'd make if your field crews got 20% more work done for the same cost?

Kind of hits you right in the stomach, doesn't it?

Here's what you need to do.

  1. Update your cost code list to include one or more tasks that you consider to be indirect. If you choose to only offer one indirect code, call it "miscellaneous".
  2. Update your timesheets.
  3. Teach your foremen what activities should be charged to the indirect cost codes.
  4. Run weekly reports showing direct hours, indirect hours, and billable hours (hours charged to job that aren't over-budget).
  5. Take necessary action to keep the indirect hours in budget.

Ron Roberts teams with Guy Gruenberg as The Contractor's Business Coach. They show contractors how to grow their businesses profitably. To sign up for their FREE Newsletter or join their Private Club, visit www.FilthyRichContractor.com.

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