There a couple of things to keep in mind when measuring flywheel housing runout with the housing mounted on the engine. The typical way is to mount your indicator (it might be a dial indicator, it might be a flywheel gauge like Snyders sells) is to mount the indicator base onto the back of the crankshaft, then rotate the crankshaft. You look for the difference between high and low, and that is the runout.
1. First and foremost, the crank has some degree of end play. It may be as little as say 0.001", or it may be 0.006" (especially on a rebuild without changing the thrust). As you use a wrench to rotate the crankshaft you are pushing against that end play and can move the crank back and forth in its bearings. Depending on where you are in the end play that will show up in your runout measurement. To try to minimize that effect I typically stand my engine vertical with the crank nut up, whack the nut a few times (gently) with a dead blow hammer to drive it backwards, and then rotate the crank a couple of times carefully to allow it to seat to its chosen position as far aft as it is comfortable. I then set up the dial indicator. It makes reading the dial indicator sort of awkward, but I think it gives as close to a true reading as feasible.
2. If you use a dial indicator, choose your end button on the indicator plunger carefully. You need a rounded end button, not a flat one. Dial indicators are not really intended to have a lateral force on them, and putting that lateral force while turning it can bend the indicator slightly in its mount, which will affect the reading. The shorter the distance from the flywheel housing to the mounting point of the indicator, the better.
3. I've found that you sometimes see a bit of jump across the opening that the starter motor goes through. I don't get too upset with that, the clutch housing will sneak those two into alignment when you mount it.
On another note, I've had flywheel housings decked like Brent describes. You need to be very careful when you are decking the surface that mounts to the block that you don't flex it during the decking process. The original housings are very weak around the lower two bolt holes, and too much pressure can crack them (as one machine shop did to one of mine). Ideally you would have the machine shop put a couple of jacks underneath the center section to remove flex when they surface that.
I just installed one of Terry Burtz's new flywheel housings on the engine I'm building. Boy, that is one beefy (and heavy!) son of a gun. Terry provides an O-ring as the camshaft seal, so I did not put a paper gasket in. Even with that O-ring on the passenger side of the engine, it did not exhibit any side-to-side runout. It still required a shim in each of the upper bolt holes (the ones that mount the mousetrap) to get good top-to-bottom runout. I think I finished out with around 0.003" total runout, and it was a bit high at the bottom where the weight of the transmission will tend to pull it down a bit.
