I just spoke at a national convention of specialty contractors. I left shocked at the number of business owners who don't know how to price their work.
My guess is that over 75 percent of all contractors don't know the right markup to use for overhead and profit. They just bid to get the work at whatever the customer will pay. These contractors continue to charge too little for the work they do and ruin it for the business owners who know how to run and manage their companies like professionals.
These contractors leave a lot of money on the table every year. They don't know the difference between markup and margin or how much to add to their bids to break even or make a profit at the end of the year. The difference between markup and margin is a simple concept to grasp and will make you more money than you are currently making. Markup is the percentage of money added to direct costs to cover overhead and profit. Margin is the percentage difference between direct costs and sales price (markup amount) divided by the sales price.
Let's take a look at a typical job:
Job Bid (Example 1)
- Direct Job Cost = $1,000
- 30% Markup = $ 300
- Job Sales Price = $1,300
- (1,000 - 1,300) / 1,300 = 23 % margin
In the example above, you are not making 30 percent; you're only making 23 percent on your sales. To earn 30 percent margin on your sales, you would have to mark up your cost 42.8 percent. Now, let me show you how to calculate the margin needed to make what you want. To determine your selling price and make the overhead and profit margin you want, you must divide your direct costs by the margin conversion rate (MCR).
- Sales Price = Direct Job Costs / MCR
Using the example above, to make 30 percent margin on the job (not markup), convert 30 percent margin using the MCR formula:
- MCR = 1.0 - Margin %
- MCR = 1.0 - .30 = .70
To make the overhead and profit margin you want, determine the final sales price by dividing your direct job costs by the MCR as follows:
- Sales Price = Cost / MCR
- $1,000 / .70 = $1,428
Job Bid (Example 2) Percentage of Sales
- Direct Job Cost = $1,000
- Markup at 42.8 % = $428 (which equals a 30% margin, actually)
- Job Sales Price = $1,428
In Example 2, the margin is 30 percent. If you are selling your jobs using markup versus the margin method, you could be losing a lot of money. Next, let's figure out how to determine the margin you need to hit your overhead and profit goals.
Determine your Overhead
It all starts with what it costs you to keep your business open. The annual, fixed, indirect cost of running your company is called overhead. Overhead comprises every cost needed to keep your doors open for the entire year with or without any work under construction. It includes your office or warehouse expenses, phones, utilities, office supplies, postage, computers, Web site, office equipment, office staff, administration costs, bookkeeping, sales, marketing, advertising, estimating, accounting, legal, banking, company insurance, and closed job expenses. Also, don't forget to include in your overhead a regular salary plus vehicle expenses for the owner or president who manages the company.
Notice what is not included in your annual overhead cost: field labor, field labor insurance, field labor benefits, field trucks, field equipment, gas and maintenance for field vehicles, job insurance, job supervision, and project management. These field costs are a part of your total job cost, as they are not needed unless you have jobs to install.
An exception needing to be included in your overhead is the non-billable portions of your project management, field supervision, field labor, and field vehicles you pay for while they are not working on a job. For example, if you have to keep paying a superintendent during the winter months, you'll need to add that portion of his salary to your overhead. And, if you can't bill out for your vehicles every day, you'll need to include the downtime days in your overhead cost.
Determine Your Break-Even
When all your jobs for the year bring in enough money to cover all of your direct job costs plus enough to cover your annual overhead costs, you break even. To make a profit, you must add your overhead costs, plus a profit margin, to your bids. Your overhead margin is easy to calculate. It is the total sum of your annual overhead costs divided by the sales you anticipate for the year (Overhead Margin = Annual Overhead Expenses / Annual Sales).
To calculate your break-even overhead margin to use on your bids to break even, you'll have to estimate the annual sales you'll be able to collect for the entire year. In Example 3 below, you have estimated three different levels of annual sales: $1,000,000, $2,000,000 and $3,000,000. For each sales level you estimate, you'll have a different overhead margin needed to add to your bids to allow you to break even.
Break-Even Analysis (Example 3)
- Annual Overhead Expenses (in all examples) = $500,000
- Estimated Annual Sales = $1,000,000, $2,000,000, or $3,000,000, respectively
- Overhead Margin to Break Even = 50%, 25%, 16.66%
Job Bid To Break Even (Example 4)
- Direct Job Cost = $1,000
- MCR = 1.0 - Margin % .50, .75, .8333
- Job Sales Price (Cost / MCR) = $2,000, $1,333, or $1,200
Obviously, though, the goal isn't to just break even when running a business. You are, after all, the one taking a risk by running a business, so you deserve a return on your business, or a profit. In the column in the June/July 2010 issue of Hardwood Floors, I'll show you how to fix your pricing so you're turning profit on every job instead of just breaking even!