Markup & Pricing

Introduction

Through out the web you’ll find blurbs for one of the best selling books on understanding markup for contractors saying:

To succeed in a construction business, you have to price your jobs to cover all labor, material and overhead expenses, and make a decent profit. The problem is knowing what markup to use. You don’t want to lose jobs because you charge too much, and you don’t want to work for free because you’ve charged too little. If you know how to calculate markup, you can apply it to your job costs to find the right sales price for your work…(Note 1)

The problem with that is the markup method described in that book (a markup based on your Estimated Total Volume Based Markup) is it can leave you in a position where you will lose jobs because you charge too much and get plenty of jobs where you’re working for ‘free‘ because you charged too little.

This article explores just how that happens and compares that method against a Capacity Based Markup Methodology.

The Story Begins

Lets pretend we have two almost identical small solo operation contractors. They’re identical in that they have the same costs and operational goals but they are going about pricing their projects via two differing methods. One contractor, Contractor A, Aaron is going to work with a Capacity Based Markup while the second, Contractor B, Bill is going to work with an Estimated Total Volume Based Markup .

Part 1 – Labor Costs

Both contractors set about figuring the real Actual Cost for their Labor.

Without considering their compensation for owning and running a business, performing office work estimating and the like they decide that they want to pay themselves a wage of $24.00 per hour (plus some benefits like health insurance and retirement) for their time out in the field which they anticipate will be spent doing the actual work themselves but that wage will also compensate them for the time they spend supervising any subs they have hired for any particular project too. They are the owners of their own businesses and the only employees which means they are exempt from the obligation having to cover themselves with Workers Compensation however they decide to do so anyway so that they are then insured if they get hurt on the job. They plug in the costs for all those items and what they get for their estimated yearly Labor Cost appears in the chart below.

Labor Cost
Labor Cost Item		$ Per Year
Base Hourly Wage	2040 hrs @ $24.00 per hr.	$48,960.00
Basic Common Burden Costs
Workers Compensation		$8255.00
FICA & Medicare		$3745.00
State Unemployment Tax		$162.00
Federal Unemployment Tax		$56.00
Benefits
Health Insurance		$4500.00
Dental Insurance		$420.00
Retirement		$490.00
TOTAL YEARLY LABOR COST		$66,587.70

Contractor B, Bill is done with his Labor Cost figuring for the time being but Contractor A, Aaron, goes on to look at how the hours he is going to pay himself for actually break down. While he is going to actually “work” for 51 weeks in the year, 8 hours a day, 5 days a week for a total of 2040 hours he knows not all of that time is going to be productive work he can charge to his client’s project budgets. He is going to give himself 5 paid holidays and a week (5 days) of paid vacation. He also plans to compensate himself for some 16 hours of training he wants to take and he figures a budget of 52 hours (about an hour per week) for downtime where he is just chatting with clients or subs or fixing tools and can’t in his mind charge that time to his client’s project budgets. That figuring works out to 148 hours of Non-Billable time so he subtracts that from the 2040 Total Hours and comes up with an estimate of 1892 Billable Hours that he will work.

He then takes that figure he worked out earlier for his Total Yearly Labor Cost of $66,587.70 and divides that by the 1892 Billable Hours to come up with a True Hourly COST for the hours he can charge to his client’s project budgets and that works out to a labor Cost of $35.19 per hour.

Billable Hours vs Non Billable Hours Worksheet
Labor Hours Item	$ Per Year
Anticipated Total Work Hours	2040
Anticipated Non-Billable Work Hours	148
Anticipated Billable Work Hours	1892
LABOR COST PER ACTUAL HOUR WORKED (2040)	$32.64
LABOR COST PER BILLABLE HOUR (1892)	$35.19

Part 2 – Fixed Overhead Costs

Both Contractors then go about figuring out their Fixed Overhead Costs (the costs of doing business that they have to pay regardless of whether they do any Billable work for clients at all). They come up with estimated budget of $18,254.10 for General Office Operation & Expenses which includes their office time spent estimating and bookkeeping as well as general office operation costs such as phone service, paper, postage, and trade association dues etc. They come up with an estimated budget for Capital Equipment for the year of $7520.00 Vehicle, Tool, and Computer expenses. They develop a budget of $5370 for marketing (cards, brochure, web site, advertising etc), they budget $700 to cover the cost of meeting with an accountant or lawyer and $100 for local business taxes. The then also put in a line of $8000 for Contingency & Reserves which is to cover for any potential overruns in any of the Fixed Overhead budget items or any Job Estimating and Bidding errors.

And then just for owning an operating the business they plan to take a draw of $8000 and they plan to compensate themselves $6000 for both the successful and unsuccessful the time they spend trying to sell their jobs to clients.

Fixed Overhead Costs
Overhead Item	$ Per Year
General Office Operation & Expenses	18,254.10
Capital Equipment	7520.00
Marketing	5370.00
General Insurance	2600.00
Professional Fees	700.00
Local & Regional Business Taxes	100.00
Contingency & Reserves	8000.00
Owners Compensation (Draw)	5000.00
Sales Compensation	6000.00
Total Overhead Costs	$54,544.10

The Total Overhead Cost of $54,544.10 works out to a weekly overhead expense of $1049.88 based on dividing that yearly figure by 51 weeks (the number of weeks in a year both contractors figure on working).

Part 3 – Net Profit and Determining the Selling Price for a Job

Both contractors in addition to the money they pay themselves as wages for field work or for salary for the behind the scenes office work still also want their companies to generate and earn a Net Profit. That Net Profit they can then reinvest in the company to grow it in some way or cash out with at the end.

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Aaron, Contractor A:

Aaron, Contractor A, since he has chosen to use a Capacity Based Markup method then looks at what he has so far and says even if he doesn’t sell any Materials at all as part of my operation or hire any Subcontractors he still wants to make a Net profit of 10% on his Sales. Looking at that he sees the business equation of:

Total Labor Costs + Total Overhead Costs + Net Profit = Total Sales (of Labor)
$66,587.70 + $53,544.10 + Net Profit = Sales (Labor)

Figuring he wants his Net Profit to be roughly 10% of Sales he multiplies $121,521.70 (the sum of his Total Labor Costs + Total Overhead Costs) by 1.11 to give himself a number for Total Sales ($134,899) of which Net Profit ($13,367) will amount to 10% of those Sales.

Total Labor Costs + Total Overhead Costs + Net Profit = Total Sales (of Labor)
$66,587.70 + $53,544.10 + $13,367.00 = $133,498.80

So Aaron, Contractor A, then takes that Total Sales of Labor figure of $133,498.80 and then divides it by the total number of billable hours he plans to generate in a year (1892 hrs.) and he come up with $70.56 which then becomes his “Loaded” Labor Billing Rate.

Aaron’s, Contractor A’s, Loaded Labor Rate Computation
Total Yearly Labor Costs	$66,587.70
Total Yearly Overhead Costs	$53,544.10
Net Profit	$13,367.00
Total Labor Sales	$133,498.80
Billable Hours	1892
AARON’S LOADED LABOR RATE	$70.56

Provided his estimates are relatively accurate if he works and generates 1892 hours of Billable time he will be paying himself a total compensation package of $73,460 for roughly 2750 total hours of work (2040 Total Field Work Hours plus in addition to those field hours he figures 255 of office work, 255 estimating, and 200 on sales) or $26.71 per hour (plus those benefits) for an average of 54 hours per week (2750 hours divided by 51 weeks).

Owner’s Compensation
Owners Wages for Field Work	$48,960.00
Owners Compensation for Office Work	$6,000.00
Owners Compensation for Estimating Work	$7,500.00
Owners Compensation for Sales Work	$6,000.00
Owners Draw	$5,000.00
TOTAL COMPENSATION	$73,460.00
plus: NET PROFIT	$13,367.00

While Aaron has created a “Loaded” Billing Rate or a selling price for an hour of his services ($71.30) that covers all his overhead, direct labor costs, and generates a Net Profit he hasn’t yet planned for what to do with the Materials and any Subcontracting he may need on his projects. If he wants to earn the same Net Profit ratio for Materials and Subcontracting that he does on his Labor where it is %10 of Sales then he can use the same method he used earlier and multiply the Materials and Subcontracting Costs by 1.11 to come up with a Selling Price and the difference between the Selling Price and the cost will amount to 10%.

So if Aaron lands a Labor Only job he can use the formula:

Estimated Number of Billable Hours the Project Will Take x Loaded Labor Rate = Selling Price

and for any projects that require him to provide Materials and Subcontractors he extends that formula to be:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x 1.1) + (SubContractor Costs x 1.1) = Selling Price

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Bill Contractor B:

Meanwhile Bill, Contractor B is taking a slightly different approach since he has chosen to use a an Estimated Total Volume Based Markup method. That method is simply described as:

Job Costs x Markup = Selling Price

or that same formula can be broken down into a little bit more detail as:

(Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price

So Bill, Contractor B, knowing what his estimated Labor Cost for the year is going to be $66,587.70 (the same as Aaron) he then needs to estimate what his Material Costs, and SubContracting Costs for the year will be and having them in hand compute a Markup that will cover his Overhead Cost ( $54,934 also the same as Aaron’s) and return a Net Profit.

This is where we encounter the first real big problem with using an Estimated Total Volume Based Markup method. For the start up contractor just how do you go about estimating what your Sales Volume for your first year in business will be?

In his book Markup & Profit: A Contractor’s Guide, Michael Stone, a consultant who advocates and teaches the method suggests you talk with other contractors already in the business to “find out what volume of work they completed in the previous 12 months” (Note 2 ). Some of the problems with this kind of research method are:

1. Most contractors you will talk to are not forthcoming with this information.
2. If they do tell you what their volume is the figure they give you is probably going to be biased to make it seem like they are doing better than they really are.
3. Or the numbers are intentionally misleading so as not to help out what they view as a potential competitor.
4. They may not be performing exactly the same kind of work that you will.
5. Without knowing how employees they have to execute the volume the numbers will be misleading. And…
6. Without knowing the distribution of those sales dollars between Internal Labor, Materials, and SubContracting you have no way of knowing whether the ratio of Internal Labor to Materials to SubContracting will be the same for the kind of projects you are doing and how you decide to contract them.

While Michael Stone does acknowledge the problems with “jerks who wont tell you anything, or who might even lie to you” he says “with a little bit of experience you should be able to weed them out” (Note 3 ). I have my doubts about the effectiveness of that and besides that doesn’t deal with the items 4, 5 and 6 on my list.

Michael Stone then offers that the first year in business remodeling companies can expect to complete a volume of $150,00 to $300,000 and the problems I see with that relate both to how much SubContracting the contractor does in that a contractor who subs out all his or her work can and has to generate a larger volume of work and there are dramatic regional differences in what remodeling or contracting in general costs so those suggested volume numbers there I feel are next to meaningless.

What I would suggest to someone using this method (but I don’t really recommend using this method anyway) is instead to decide just what kind of work you will want to focus on and create a hypothetical cost estimate for that kind of project done how you would contract it and then see what the ratio of your Internal Labor to Materials to SubContracting will be. Take that ratio and then using the figure for your yearly capacity for labor hours extend out the number for Material and SubContracting Costs according to those ratios.

Doing this our hypothetical Contractor B, Bill, come up with a breakout of his Estimated Job Costs of:

Total Job Costs
Labor	$66,587.70
Materials	$54,752.20
SubContracting	$34,660.80
TOTAL JOB COSTS	$156,000.70

Like Aaron feeling that he want to earn a 10% Net Profit on his Sales Bill then adds to that estimated figure for Total Job Costs $156,000.70 the figure for Overhead of $54,544.10 (which is the same as Aaron’s) and then multiplies their sum by 1.11 to come up with an Estimated Sales Volume for the year that includes that 10% of Sales for Net Profit which comes to Total Sales of $228,154.72.

Bill’s, Contractor B’s, Sales Summary
Labor	$66,587.70
Materials	$50,752.20
SubContracting	$34,660.80
TOTAL JOB COSTS	$152,000.70
OVERHEAD	$54,544.10
NET PROFIT	$22,609.93
TOTAL SALES VOLUME	$228,154.72

To price his jobs Bill now needs a Markup figure he can multiply the Job Costs by to come with a Selling Price for any specific job. Taking the estimated Total Sales Volume and dividing it by the Total Job Costs for the year Bill get a figure of 1.50 ($228,154.72 / $156,000.70 = 1.501) and that then becomes his Markup.

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At first glance it looks to Bill as though he has chosen the much better method. If things go according to Hoyle he will earn the same compensation as Aaron but will also have a company that will generate an estimated $23,202.82 in Net Profits to Aaron’s $13,367.39.

Bill’s Owner’s Compensation & Net Profit
Owners Wages for Field Work	$48,960.00
Owners Compensation for Office Work	$6,000.00
Owners Compensation for Estimating Work	$7,500.00
Owners Compensation for Sales Work	$6,000.00
Owners Draw	$5,000.00
TOTAL COMPENSATION	$73,460.00
plus: NET PROFIT	$22,609.93

But in Aaron’s planning he never had to make any pro forma estimates as to what he was going to sell in the way of Materials or SubContracting but if he did since both Aaron and Bill are going into the same line of work Aaron can actually use the same projected estimates for Material and SubContracting Costs. Looking at that if Aaron generates $50,752.20 in Material Costs and applies his 1.1 markup multiplier to those costs to come up with the Selling Price for those Materials of $56,334.94 with $5,582.74 of that being Net Profit. And looking at SubContracting the same way on Costs of he generates $34,660.80 in SubContracting Costs multiplying them by 1.11 to get a Selling Price of $38,473.49 with $3,812.69 of that being Net Profit. You then take Aaron’s Net profit on Labor of $13,367 and add to that $5,582.74 and $3,812.69 you get $22,762.43 a figure virtually the same as Bill’s $22,609.93.

Part 4 – Comparing The Two Different Methods in Practice

Now w e’ll take a look at the the two different markup stategies and see how they work in three different pricing scenarios. A Project with Labor, Materials, and SubContracting in the Same Ratio That Used in the Markup Planning Process with a

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Conclusions

When considering the scenarios I outlined above contractor who use the Estimated Total Volume Based Markup method that Contractor B Bill uses will rationalize and argue that while you’ll a little bit of money on some jobs (like in the Job 2 scenario) that will all balance out in the end because those losses will be offset by the surplus profit they’ve earned with the jobs they’ve gotten like are described in the Job 2 scenario. However on closer examination we see that’s really not what happens at all. In reality contractors like Bill wont get the Low Relative Cost of Labor to High Cost of Materials, and SubContracting jobs like Job 2 because they’ll be pricing themselves out of the market. The reality is the jobs they will get will fall into the standard mid range mix model like Job 1 and the High Relative Cost of Labor to Low Cost of Materials, and SubContracting jobs like Job 3 that they will do at a minimal profit or at a loss.

Meanwhile Contractor A Aaron will split the standard mid range mix model with Bill, he’ll will get the Low Relative Cost of Labor to High Cost of Materials, and SubContracting jobs like Job 2 since he is priced correctly and while he would still earn his company a decent and fair profit with the High Relative Cost of Labor to Low Cost of Materials, and SubContracting jobs like Job 3 he in all likelihood might end up losing them to Bill. While I am sure Aaron will be annoyed at losing a job to bid he knows is a loser, (what contractor doesn’t complain about that?) he should be content and secure in letting those jobs pass.

In a tight construction market like we are in now could and should Aaron drop his price to compete with Bill on those High Relative Cost of Labor to Low Cost of Materials, and SubContracting projects? We’ll examine that question in another article here in the near future but for the time being Aaron is safe and financially secure losing those jobs to Bill.

In the first chapter of his book Pricing for Profitability John L. Daly writes:

… Three things can happen when establishing prices, and two of them are bad.

1. Overprice and lose a sale that would have been profitable at a lower price.

2. Underprice and make and unprofitable sale

Only the third outcome is favorable:

3. Price appropriately and make the sale as well as a profit

Although this is an oversimplified view of a complex issue, many companies are burdened with pricing method that consistently give away profitable sales to competitors while undercutting those competitors on money-losing propositions. When these companies make a sale than actually produces a profit, it often seems to more by accident than intentional design.

Many companies believe falsely that they are competent at pricing. Many president of small companies will say, “Pricing is an art. I know that our pricing is good because I do it myself.” Pricing is not an art. However, a well-designed pricing model make be beautiful in the same way as a well-designed piece of machinery. Pricing is a science as much as the design of that machinery is a science. Knowledge is power in pricing. Although pricing for profitability allows considerable latitude for creativity in structuring a deal, pricing remains as much a science as marketing, cost accounting, business strategy, engineering, and economics—the disciplines that converge in product pricing. If the person responsible fir establishing price says, “Pricing is an art,” it is a good indication that he or she is missing much of the basic data necessary to make informed pricing decisions. (Note 5)

So if the Estimated Total Volume Based Markup method is so flawed should anybody still be using it?

In his book Running a Successful Construction Company David Gerstel writes about the potential problem using an Estimated Volume ( aka Uniform Percentage) based markup starting on page 166:

The uniform percentage method has the great appeal of simplicity. It is adequate for a construction company that does projects of fairly uniform size and type. A uniform percentage markup can work for a builder specializing in moderate-size residential additions or small retail store interiors and never straying far beyond his or her niche. However, you can run into trouble using a uniform percentage if you move away from a narrow range to a much wider range of projects–or if you experience large variations in your total volume of work.

To understand the potential problems, think of your company as a shop with “X” amount of capacity and with all of your overhead costs going to support that capacity. if you are in the early stages of your career and are working as your own project lead as well as general manager of your company, your capacity may be one job at a time. Later you may employ three lead, each of whom runs a job so you have the capacity of three jobs. For practical purposes–and here is the key point–you can generally figure that each lead uses the same amount of your overhead support, regardless of the size of job he or she is running.

As the top sidebar at right suggests, those jobs can vary greatly in terms of the direct costs of building them, yet take roughly the same length of time with the result the small one will soak up as much of your capacity–as much overhead–as the larger one. When that is the case, if you are using uniform percentage markups, the small job is recovering less than the overhead needed to support it. If you have a year packed with such jobs and you are marking up with a percentage derived from a prior year of larger jobs, you may end up falling far short of recovering your overhead, as the figures in the bottom sidebar illustrate.

Capacity Based Markup

Because of the limits of the uniform percentage method, companies doing projects of varying size and experiencing large variations in volume year to year need another method of marking up for overhead. I call this method “capacity based markup.” It works like this:

• Figure Capacity
• Figure overhead for the year
• Figure amount of overhead you need to recover weekly per job
• Figure the number of weeks a job will take
• Multiply your weekly overhead figure by the number of weeks to get get the overhead you need to charge on the job

[...]

… and it goes on with more on using a Capacity Based Markup but I don’t want to violate the fellows copyright so by the book.

While Gerstel writes “The uniform percentage method has the great appeal of simplicity” I will argue that while the formula is simple ((Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price) working with it and monitoring it is not so simple when jobs vary in size (small job to large job) and ratios of internal labor to materials and subcontracting.

In his manual for using the PROOF markup methodology (How to Survive & Prosper in the Contracting Market) Irv Chasen writes:

“The PROOF program has stressed the importance of recovering all overhead cost as a percentage of labor cost. Labor itself is the best measure of time, and it is the lapse that generates most overhead cost. Depreciation, rent, insurance, taxes, administrative salaries, and most other major fixed-overhead items are paid weekly, monthly, or annually, and are therefore functions of time.

Since field labor is usually paid by the hour, day, or week it obviously becomes the best single measure of time within the construction or contracting industry. Further it is labor which creates all of the variable-overhead cost.”

Only after that introduction does he get around to saying:

“However, some contractors still prefer a system which which also recovers a portion of their fixed-overhead cost as a percentage of materials used and/or subcontractors employed…”

For the next three pages explain how that method works but then in the very next section called Nine or Eighty-One Combinations he illustrates one of the big problems with using that method over a PROOF (Capacity Based) methodology.

“Variations in the budgeted fixed and/or variable overhead expense can occur. Costs can remain as budgeted , or they can increase or decease. Here we have only three things that could happen. Budgeted field labor cost would also be subject to the same three possibilities; thus we have nine possibilities, considering both total overhead expense and field employment (3 x 3 =9).

When subcontracting enters the overhead recovery picture, again the same possibilities (more, less or the same) can occur with regard to achieving the budgeted goal for subcontractors employed. Now we have 27 possibilities which could occur (3 x 3 x 3 = 27).

Now if materials too are to be considered as part of the overhead recovery, these materials are also subject to the same three possibilities: the actual cost may be more than, less than or the same as the amount budgeted. The possible combination of results increase to 81 (3 x 3 x 3 x 3 = 81).

Certainly it is much easier to monitor nine possibilities, or 27 if necessary, than if we it necessary to monitor 81 by bringing material into the overhead recovery procedure…”

The reality again is if you plan to use an Estimated Volume ( aka Uniform Percentage) based markup method to price your work monitoring it to make sure it is working for you is going to be at least nine times more difficult than using a Capacity Based Markup. If our Contractor B, Bill wants to compete in the market on the same level as Aaron he will have a lot of work to do to make sure he is priced correctly to win jobs and cover his overhead and quite frankly having real all the books and articles on the subject that I can find I don’t see where the advocates of an Estimated Volume Based Markup describe just how to go about all that monitoring and tinkering.

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Further Reading & Tools

Relative Income, It’s a great concept so what is so many of us don’t seem t get it.

As I was working today I was re-reading the The 4-Hour Workweek: Escape 9-5, Live Anywhere, and Join the New Rich, by Timothy Ferris by listening to the audio book edition as I was working today I was remnded of a passage I really enjoyed when I read it the first time through.

Two hard-working chaps are headed towards each other. Chap A moving at 80 hours per week and Chap B moving at 10 hours per week. They both make $50,000 per year. Who will be richer when the pass in the middle of the night? If you said B, you would be correct, and this is the difference between absolute and relative income.

Absolute income is measured using one holy and inalterable variable: the raw and almighty dollar. Jane Doe makes $100,000 per year and is thus twice as rich as John Doe, who makes $50,000 per year.

Relative income uses two variables: the dollar and time, usually hours. The whole “per year” concept is arbitrary and makes it easy to trick yourself. Let’s look at the real trade.

Jane Doe makes $100,000 per year, $2,000 for each of 50 weeks per year, and works 80 hours per week. Jane Doe thus makes $25 per hour.

John Doe makes $50,000 per year, $1,000 for each of 50 weeks per year, but works 10 hours per week and hence makes $100 per hour.

In relative income, John is four times richer.

… The top New Rich mavericks make at least $5,000 per hour.

The other day I was in one of the discussion forums and I heard one contractor telling another fellow that was getting set to start out on his own that he could expect to spend

“…65 hours working [in the field], another 20 for office crap”

…and I thought that was just insane. That’s not a life , it’s a self imposed prison sentence and in my estimation evidence of poor business design. To his credit the guy who was putting the pieces together and doing the planning to go out on his own wasn’t buying into any of that insanity. The insane guys who work that kind of schedule (and there are lot of them out there) are often the ones who don’t have a decent or respectable Net Profit margin in place and try to make up for that lack by doing it “in volume“.

Generally speaking contractors need to work smarter learn to substitute that for working harder and longer.

Perhaps the key central premise of the booke The 4-Hour Workweek is that you are only “rich” if you have leisure time to enjoy yourself. It probably should go on the contractors required reading list.

There’s an interesting article in Reuben Swartz’s Dollars and Sense: The Pricing Blog entitled:
Why Starbucks Coffee Is Cheap that presents a rational and explains that "if caffeine is what you want, and you want it in volume, Starbucks is your low-cost provider".

While that may be true as far as ‘pricing’ is concerned in the total realm of "caffeine providers" which includes Coke, Pepsi, Red Bull and amongst others is that really what people"buy" when they go to Starbucks? I drink nothing but de-caf regardless of whether it’s soda or coffee but I still prefer Starbucks and my local cappuccino bar to the coffee from my local delis, bagel shops and other establishments.

So what am I buying and what am I paying for?

It’s the "Experience" I get. If Caffeine is a commodity and as long as the consumer views it that way then Starbucks is one of the low cost providers (I think the delis and bagel shops beat them there and are the ultimate bottom line leader in the low price for caffeine category) when compared to buying Coke, Pepsi or some energy drink. But in their book The Experience Economy: Work Is Theater & Every Business a Stage
author Pine and Gilmore describe something different that often goes on and certainly takes place for me when I buy my coffee in that I’m buying the ambiance and "eatertainment" as the authors describe it of the cappuccino bar. In fact I’m not only not buying the caffeine I’m also probably not really buying the coffee either. I buy my coffee in Starbucks and my local shop, Perks, because of the experience it gives me. I’m buying it there for the way it makes me feel.

For a long time there a quote I like that I repeat over again from time to time that I’ve attributed to Jim Collins & Jerry Poras authors of Built to Last: Successful Habits of Visionary Companies.

Profit is like oxygen, food, water, and blood for the body; they are not the point of life, but without them there is no life.

I did a search online this evening to try and verify my sourcing and found the full quote:

Profitability is a necessary condition for existence and a means to more important ends, but it is not the end in itself for many of the visionary companies. Profit is like oxygen, food, water, and blood for the body; they are not the point of life, but without them, there is no life.

But in addition to that verification I also found a great post in another good blog with “Profit is like oxygen,…” commentary.

In the Talentism Blog I found the article: Principles Of Talentism: Part 4 – Purpose Before Profit

Jim Kaslik one of my online friends and acquaintances from Fine Homebuilding Magazines BreakTime Forum (where I know him as Cloud Hidden) who designs homes as sculptural concrete forms (they’re more than just domes) posted a link in the BreakTime forums to a great article he discovered in the blue flavor web site blog entitled Pricing a Project that I think is a gem and while it’s written from the viewpoint of a design, development and consulting company there are plenty of lessons in it that building and remodeling contractors can learn from too.

In addition to reading that article on pricing I would also think that most of the building and remodeling contractors I know would really enjoy taking a look at the kind of stuff that Jim does in his practice so take a trip to the Cloud Hidden Designs, LLC web site (CloudHidden.org) and take a look at the great designs he has developed.

I was down at our local coffee shop this Sunday morning and while sitting outside drinking my coffee I was reading through an old issue of CWB (Custom Woodworking Business) where I came across an article entitled "Pushing the Limits—Doing the unusual jobs ‘that nobody else wants to do’ is standard fare at Philip Sicola Designs." About halfway through the article there were a few idea on pricing that got me to thinking about just what was being said.(The emphasis on certain phrases are my own)

The idea of pricing on the basis of “perceived value” requires a different mindset for a custom woodworker, Sicola says. “When a cabinetmaker starts his own business, he figures prices by thinking, ‘It will take me 10 hours, I’ll have so much in material, plus a certain percentage of overhead,’ and that’s how he figures the cost. But I don’t. In high-end custom work, what’s important to the client is the perceived value. Money is not an issue. I base my price on what I perceive to be the value of the project, and then I work backwards to figure out what to do to equal this value. That’s how I do all my jobs.

“The perceived value is partly from the client and partly from you,” he continues. “You both agree that something is worth $10,000. It may only cost you $500 to build, or it might cost you $12,000 to build. You have to control your own costs to stay within the budget
you create. I have sold things where the actual cost to build them was only 10 percent of the price and I have sold things where the cost was 130 percent. That’s what you call the learning curve.

This fireplace surround is about 25 feet tall. The curved fireplace panel is a softwood substrate covered in aniline dyed silverleaf. The center portion is textured resin covered in LuminOre. This project cost over $50,000. Back lighting accents each side.“Once I realize what the value of a piece is, I won’t come down on the price. However, it does take a little bit of nerve to do that and say, in essence, ‘I really do believe in myself,’” Sicola adds. “And it’s risky. I give prices on a job before I even know how to do it. I’m on the leading edge all the time, and I think pricing is one of the hardest things in this business. I don’t always succeed in making money, but most of the time I do.”

Sicola also says that his standards are very high and he always give his clients the value they expect. “The perceived value has to be real, you can’t just make something up,” he says.

While I often find builders and remodelers who just plain under price their work becuase they don’t know what their real costs and productivity is I think there are certainly a large number of contractors who ‘leave money on the table’ becuase while they are covering their cost and generating a profit they fail to see the “value added” they are sometimes delivering with the services they provide.

I just sort of accidentally and clumsily stumbled on to "selling by perceived value". Years ago I got a call to look at a difficult stair railing project. I found out from the project manager when I got there that several other stair shops had been there to look at the job and said it couldn’t be done. The builder told his project manager to give me a call even though at the time I might not have been really considered a genuine stair and railing shop because he said that I would at least figure out a way it could be done ( I was seen as a problem solver).

Looking at the job I said "Yeah sure it could be done, but it wasn’t going to be easy". The railing they wanted was iron and brass balusters with a solid cherry cap rail. Right there I knew they were talking about getting a specific look and not shopping for a railing that would "meet their budget". The "impossibility" that the other stair shops saw that I just saw as a "difficulty" was two helical wreath turns that would have to turn 180° and drop 28" on a 4-7/8"radius. I knew it could be done because I had seen it in books although I had never seen it done in actuality.

Driving back home from looking at the job I was going over the wreath turns in my mind thinking about how I would do them and how long it would take. Thinking back to a sculpture I did in college, carving a chain out of a solid block of wood I figured it would take me a full day to shape each wreath from a glued up blank. So I began to think…$55 dollars an hour times 8 or 9 hours…works out to between $440 and $495 labor … the cost of the cherry for that piece…wide thick stock at $6.5 to $8.50 a board foot… lots of waste…that would be about $60 to $100… for each wreath I should charge something like $540 to $600…when all of a sudden… a little voice in my head said "HEY WAIT A MINUTE!

These two pieces are the only obstacle keeping all those other stair shops from being able to execute the project the way the end-user-homeowner wanted it….What are those two pieces really worth then? …What are they worth to the builder who has promised the owner that he could get the job done for them just the way they really wanted it?… Arbitrarily off the top of my head I then decided to price the project based on something like a $2400 price for one wreath and a $2700 for the other.

It was right then in the midst of all that visionary thinking and figuring that I got pulled over for speeding. Lost in thought I had no idea how fast I was going.

Well, altogether with all of the other railing work to be done that only amounted to a 5% or 6% increase in my total project price but those two pieces were earning my company money at the rate of around $240 per hour (they ended up taking just a few hours longer than the 8 or 9 hours I guestimated). My price was accepted no problem and the builder had his markup on top of that when he presented it to the client.

(For the curious here’s how that project and those wreath turns actually turned out )

So I learned a lot from that one project that forever changed the way I have priced projects since then. After working up a basic estimate for a project I look at the whole project again and try an break it down into smaller component parts that I can rightfully charge a premium for. I’m also now genuinely in the stair and railing business since we can fabricate stuff that other shops can’t or wont.

There’s no real valid formula yet for determining that pricing premium. Right now since it’s usually me and not one of the troops that has to fabricate those parts personally I think about just what would it take to get me off of my butt and make that part for a client when I could be doing something else I really enjoy like watching a Yankee game. Seriously that’s how I think about approaching and determining a perceived value and ultimatly a price. Product PRICING is subjective thinking as opposed to the objective and pragmatic thinking involved product COSTING.

That makes me think that there are really two part to the equation. What’s it worth to the client and what’s it worth for your company to take the risk in attempting to produce the piece? You also really have to know your client’s preferences and values(in this case a builder) and the their clients expectations and tastes too (the homeowners).

I just recently re-read an article I had read a while back entitled How Much Profit Is Enough? by George Hedley of Hard Hat Presentations and it got me re-thinking on the concept of Net Profit.

I’ve talked with a bunch of contractors over the last few years who when talking about Net Profit cite either that the Remodeler’s Cost of Doing Business Study that shows remodeler’s typically reported Net Income earnings (net profits) falls in the range of 6.2% to 8.4% so that’s what they target. Interestingly the study I have at hand (1997) says "The average net profit reported by all of the remodelers responding to the survey was 6.8% of sales" but then goes on to say that "The net profit of the most profitable firms in the study (the top 25 percent of respondents ranked by profitability) was 15.6 percent…". I then ask myself why are so many contractors targeting the average rather than the most profitable performance level?

Michael Stone on pg. 186 of his book Markup & Profit: A Contractor’s Guide says "You should be making a minimum of 8 percent net profit" but there’s really no reasoning or discussion on it beyond that sentence. Ellen Rohr in her book How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love doesn’t really make any recommendations but does use a pretax net profit target of 20% in one of the contractor examples she profiles. In the PROOF manual on markup and pricing, "How To Survive and Prosper In The Contracting Market", on page 66 Irv Chassen writes "It is not PROOF’s purpose to recommend or suggest the rate of profit markup…" although in the contractor examples he profiles he often uses 8%.

Still it seems no one offers any reasoning or arguments as to what’s a good number to use.

However just the other day when I re-read that article How Much Profit Is Enough? he presents some real reasoning as to how to think about Net Profit. First off he writes about a really good point when with "The goal in business is NOT to stay in business. The goal of business is to ALWAYS MAKE A PROFIT" that I don’t think a lot of contractors get. How many contractors do we all know who’s businesses really aren’t businesses at all but just their vehicle to give themselves a job.

But then he goes on to say:

—"If asked to invest $100,000 in a friend’s new start-up business, what return would you want? 10%, 15%, 25%, 50% or More? After considering all the risks, I would never invest in a new business that didn’t offer at least a guaranteed 15% to 25% return on equity or capital. Likewise, the minimum pre-tax net profit goal for your company should be 15% to 25% return on equity (or higher)."—

Return on equity, that’s a different way of looking at it that I haven’t heard anyone else say or write about that I can recall. Equity being defined as the net worth of a company or what kind of money the owner has invested in getting the business up and rolling makes it makes a lot of sense to me to figure Net Profit as a return on that investment.

Using his model and lets say you were a start up and had invested $ 100,000 in getting things rolling by buying trucks equipment and setting up a payroll reserve you would then want a $20,000 return on that investment (in addition to paying yourself a salary or wage). The for example if you were using a Capacity Based Markup strategy you would then take that $20,000 goal and divide it by the number of billable hours you expected to generate in a year and add that to any markup figure you had already figured on for covering your overhead.

If you been in business for a while and your company’s net worth is $300,000 like in his example you would want to get a $60,000 return on that investment.

Those dollar figures you could then reverse engineer into a percentage of sales and that 20% Return on Equity might then appear anywhere within a range of the range of 6% to 20% of sales in residntial remodeling or even the 2% that typical commercial contractors getting. Does that make sense? How’s that sound? I do think that’s a better more rational way of looking at Net Profit than just plugging in some arbitrary percentage just because someone says that’s what you should use.

As part of an online discussion/debate regarding the validity of a a Capacity Based Markup system (JLC-Why the PROOF System is Illogical) Allan Edwards of Allan Edwards Builder; Houston, Texas presented me with the "challenge" to show how a Capacity Based Markup system (aka PROOF) could be used to "Price a house".

As a challenge, I will list the following 16 categories from the 200 or so on my estimate sheet. These are broad categories of cost. Maybe you can explain how, using PROOF, you would price out this house. Land $400,000 Arch $20,000 Permits $10,000 Foundation $70,000 Framing $100,000 HVAC $20,000 Electrical $20,000 Windows $40,000 Drywall $20,000 Millwork $100,000 Paint $40,000 Tile Mat $20,000 Tile Labor $20,000 Insurance $20,000 Loan interest $40,000 Realtor Fees $60,000 Total Cost $1,000,000. Some of the cost are material and labor from subs (turn key), some are material only, some are labor only, some are soft costs. All work is subcontracted. Assuming these were all the costs associated with building a house, what price would you stick on it and what method would you use? Also, overhead is about $30,000 per house.

Well to answer the question in new home construction, especially with a spec home, I wouldn’t use PROOF or any other markup method for that matter to "Price" a home. There is a subtle but important difference between "Pricing" a home and "Costing" one.

In Pricing a home there are other Value considerations that don’t necessarily appear on a balance sheet. A home also has intrinsic value based on just where it is being built and even how it is situated on it’s lot. A home costing 1,000,000 being built in my neighborhood in Katonah NY would be worth considerably less than the same exact home built 1 mile away in the Mt Holly neighborhood or 2 miles away up on Girdle Ridge near Caramoor. there are other factors that effect a homes price too such as noise (how close the highway or airport it is), the school system the house is in etc . Indeed building that same exact home 5 miles to the west of where I am in Somers or Yorktown NY the house would be Priced less.

In a May 2002 Professional Builder article Pricing Opens the Door to Profit management consultant Chuck Shinn was quoted as saying:

“Buyers decide what they are willing to pay for a house,and they base their decision on the value they see in the product, not on the builder’s costs. If you buy land poorly and build houses inefficiently, cost-based pricing can lead to over-priced houses that won’t sell. We still see that a lot. But today we also see underpricing because cost-based models don’t take into account the constant movement of supply and demand in the marketplace or the escalating value of a location.” (my emphasis)

But the article also goes on to say

Shinn, president of the Colorado-based Lee Evans Group, estimates that 80% of builders use cost-based pricing formulas. Sometimes they work, he says, but only because the prices fall, by chance rather than design, in the range where the market sees value. Shinn counsels that a better approach is to find the product the market favors on a particular site — through diligent market research — and the price the market will pay for that product, even before closing on the land.

So if your building a spec home it a better approach to take a Top-Down approach to pricing based on the intrinsic value the home and land have to a potential buyer and work backwards to see if you can then build that home for a cost that leaves you with the Gross Profit you need and the Net Profit you want to generate. It’s a business strategy also known as Target Costing.

But putting those Pricing considerations aside we’ll look at the project from a Bottom-Up (cost-based) perspective.

I’m not at all sure at all why Allan put the challenge to me in the way that he did. In the discussion of any Markup System whether it’s a Traditional Volume Based Markup system such as Walt Stoeppelwerth, Michael Stone or Alan Hanbury advocate and talk about or a Capacity Based Markup system (aka PROOF) such as Irv Chasen, Ellen Rohr, David Gerstel and I advocate the discussion at it’s core roots is about how Overhead gets allocated. In Allan’s challenge to me he has already allocated overhead to the job (although we don’t know for sure just what method he used).

However if I was the builder and wanted to cost this house I would do just what I described in my post #15 in that discussion:

If I’m a builder and I’m generating $3000 dollars in Business Operational Costs (aka Overhead) per week ($156,000 per year) and I want to look at my business through a Capacity Based (PROOF) Markup System I can plan to recover that overhead a couple of different ways.

If I build 6 of pretty much the same house in a year I can take that $156,000 and divide it equally among the 6 houses. So with each house I should expect to recover $26,000 of my company’s Overhead costs. I would then take the Direct Job Costs add to that the $26,000 and since I’m not taking a salary out of that Overhead I would then also add whatever I wanted to make personally on to that sum.

Another way I could look at it is I figure I’m going to put in 2000 hours working building houses each year. I’m going to build six houses in a year but they aren’t the same house and are going to require different amounts of my time.

House 1 will take 410 hours of my effort.
House 2 will take 210 hours
House 3 will take 320 hours
House 4 will take 270 hours
House 5 will take 290 hours
House 6 will take 500 hours

So figuring each hour of my time essentially generates or accounts for $78.00 of Overhead ($156,000 divided by 2000 = $78) I need to spread that $156,000 respectively amongst those houses so I get:

House 1 @ 410 hours accounts for $31,980 of Overhead
House 2 @ 210 hours accounts for $16,380 of Overhead
House 3 @ 320 hours accounts for $24,960 of Overhead
House 4 @ 270 hours accounts for $21,060 of Overhead
House 5 @ 290 hours accounts for $22,620 of Overhead
House 6 @ 500 hours accounts for $39,000 of Overhead

And like the other example you take the houses Direct Job Costs add on the respective Overhead charge and then add to that what you want to make on the house.

That said reverse engineering the $30,000 Overhead allocation that Allan gave me I probably would have figured that that house would consume 384 to 385 hours or 19.23% of my company’s capacity.

My recommendation for Pricing the house would be as follows:

Direct Job Costs + Overhead Allocation + Consideration for The House’s Intrinsic Value = House Price

$1,000,000 + $30,000 + Consideration for the The House’s Intrinsic Value = House Price

A couple of years ago in Fine HomeBuilding’s Breatime Forum a fellow wrote:

“I live in houston and I am a trim carpenter. I do such a variety of things that I never have know the going price of some of the work that I do. I asked this same question here at FHB and i was told then that I shouldnt get involved in footage rates; that I should price by the job. I generally do that but I would still like to know the going rate on some things so I can stay semi-competitive. Example:

I have a woman who wants crown installed in all of her house. 40 feet of it is about 25 feet up in her entry way. She also wants it painted. She also lives 25 miles out in the boonies, ( no stores within 10 miles). I want the job but I am REALLY REALLY REALLY tired of bidding a job and realizing midway that I underbid ,….AGAIN!!! On the other hand I don’t want to miss out on the work. (plus, she is sorta cute, he he). I am not asking for a free bid I just wants some input on factors that would affect the price. Honestly!, I am tired of underbidding. I mean damn tired of it. I have jacked my prices up 2 times when I was busy and didnt mind if I got the job or not. Both those times I didnt get the job. 80% of my jobs I realize that I should have added a little more to the bid. I always write it off as inexperience or a learning experience. Other contractors I know say that I am too honest and thatI should remember that i have a family to feed. On the other hand my repeat clients say that they like me because I am hobnest and fair; which explains whyI have repeat clients. Any help would be appreciated thanks.”

I wrote in reponse:

Cutawooda- the best I could do is tell you what we would charge for your project and you might take it from there either rejecting or accepting our price and the mechanics of how I came up with it. However I will tell you right off the bat we do not sell our projects on the basis of staying competitive. You either want or need us to do the project or not.

1. I don’t care what everyone else charges.
2. I know what it takes for us to do the work
3. I know what it costs for the people I use.
4. I know what I want for a return on my investment in my company. (In other
   words I know what I want to make)

BUT having not seen the project I still need some more information.

1. How much total crown for the total project?
2. Are you supplying the crown?
3. What kind of crown? (hardwood, softwood, urethane, or plaster)
4. What size crown?
5. What kinds of joints? Miter, cope, scarfs?
6. Any tough joints or a a higher than average number of joints?
7. You mention 40 feet of it is about 25 feet up in her hallway can a scaffold
   be set up easily in that space without damaging the floor or walls?
8. What other temporary protection will need to be set up elsewhere?
9. What size crew do you plan to deploy or is this a one man job in your mind?
   ( You made no mention of your crew if you have one)
10. Painted how? Prime and two coats or what? We virtually always paint and
    then install all our millwork and then schedule a post installation touchup
    or final coat.

You shouldn’t get "hung up" on linear footage rates but you have to have an idea of a linear footage rate as a base price to which you can then modify specifically for a project given conditions. In other words if the typical crown molding price is $8.50 per foot for a normal room ( 8′ to 10′ ceiling) then that price needs to be modified for the difficulty or working up 25′ on a scaffold plus the cost of setting up and taking down the scaffold.

With regard to your statement:

“On the other hand my repeat clients say that they like me because I am honest and fair; which explains why I have repeat clients.”

Watch it! The real danger in that statement is you actually don’t know whether they like you because you are so "honest and fair" or because you are so frigging cheap. Your repeat clients are never going to tell you the truth about what they say about you behind your back. Translation: more often than not "Honest and Fair" is client speak for "frigging cheap".

He then replied back :

“Thanks for your response.

Actually, I am pretty good at trimming. I am a one man crew and got a good rep for doing quality work. The tall stuff I was going to get a helper and another 24 foot ladder. (ladders since there is a stairway obstructing). It is preprimed fj crown. 4 5/8

10 foot ceiling in the rest of the house. Front room she want a squares on the wall below her chair rail to immatate wainscotting. Probably around 12 of them.

I was going to prepaint everything as you do, install it, and then t-up.

total footage on the crown was around 200. 40 of it was 25feet up.

the wainscotting was going to take me around 2hours I figure. Layout about 30 minutes and 1.5 install.

Also, I need to invest in a larger chopsaw. My 10 inch doesnt cut 4 5/8. this is the third job I have recieved that wanted taller crown and its a pain in the *% without the right tools.

I figured the job at $1600.00 that is time and material. What do you think?

I am REALLY trying to be competitive. But I am really trying to “cross the line” and become a business man as well. And I am ready to cross over from “just making it “to assuming the a more responsible position and making some money. I have seen too many “hot shots” go out and experiment on a clients home only to fu.. it all up. I am so cautious about doing good work and casting a “Knowledgeable appearance” , that I found it easier to be a sub contractor and hide behind the skirt of the contrctor who hired me. And it is alot easier that way. Let them do the figuring. But I have seen others workmanship, and I have seen their bills to the clients, and I realize that I am doing better work and charging less money. I cant avoid the occasional handyman or hispanic that comes in and underbids me by 80% but I can learn from guys like you and avoid an empty bank account because I forgot to “pad ” for the days when its a rain out or when the phone just doesnt ring. (The latter just happened for 2 weeks).”

I then came back again with:

Okay Cutawooda, Nothing long with lengthy posts per se. Ya gotta say what ya gotta say to get your point across. I came up with a Price of $1740, wainscoting not included with my Costs coming in at $1130 (costs being Wages, Labor Burden & Materials). For this kind of small project we then markup materials 30% and markup the labor subtotal 65%. The wainscot thing was unclear to me so I ignored that in all my stuff. I’ll try and give you the break down of just how I came up with that price as soon as possible so you can pick it apart and modify it. Just as a point of reference there we two Labor Billing Rates I used in computing this project see the table below.

Labor Rate Worksheet

	Rate Pkg	WC Rate	Fixed OH	Labor Cost	Company Markup	Billing Rate
		20.6%	16.8%		65%
Carpenter-A	$35.00	$7.21	$5.88	$48.10	$24.05	$79.40
		20.6%	16.8%		65%
Carpenter-B	$25.00	$5.15	$4.20	$34.40	$22.36	$56.80

It going to take me a little while to write out and illustrate how I came up with my price in HTML but hey that’s a start.

And a day later to explain that estimate I wrote:

The Crown Installation Estimate

First of all I view one of the the jobs of the estimator as a little more than just entering numbers from an estimating book or database on to a spreadsheet and then totaling it all up. I think the estimator needs to design how the project is going to be handled. What’s going to get done, in what order, how, and by who. That’s all because if it’s not down the way he or she planned it then when it comes time to perform the forensic Job Costing on the project you’d be comparing apples to floppy disks. They’re not even remotely similar.

In the case of this Crown Installation Estimate I divided the job up into three hunks, chunks, quanta, phases or what ever you want to call then and estimated each discrete hunk separately. I actually call them "pocket" estimates to metaphorically imply that they are small easily handled hunks of information that you could keep in your pocket. I try to keep them as a discrete contiguous group of tasks that can be done as a whole. That helps later in both scheduling the work and defining payment schedule parameters. You could also think of these chunks as Work Orders. Essentially any client project estimate can be broken down into several individual work orders.

For the purpose of estimating I divided this project up in to three chunks.

1. Set-Up & Preparation
2. The Trim Installation
3. Painting (final touch-up) and Takedown/Close-out

1. Set-Up & Preparation
I figured to do this project I would plan to have one my carpenters go off to Home Depot to pick up some of their primed finger jointed trim. He would then return to the shop and -lay the stuff out > sand the primer > spray back and fronts with Benjamin Moore White Metal Wood Enamel. He’s then done for the day with that project and can move on to something else. Probably 4 hours of time but I estimated it at 5. The Hourly Billing Rate for that carpenter (what I call a Carpenter-B) is $56.80.

Set-Up& Preparation

	Matl		Labor		Total	MHrs
Costs		$0.00		$172.00	$172.00	5
Markups	35%	$0.00	65%	$111.80	$111.80
Price		$0.00		$280.00	$280.00	5

Just a quick note here, These figures are copied right from my estimating program and it automatically rounds of the Price line so 172+111.80=283.80 which is then rounded off to $280

---

2.The Trim Installation
For the next phase I selected a Unit Cost from our Internal Cost Database for the Trim Installation and entered it twice. For the first entry I filled out the Quantity as 200 for the total Linear Footage of the Project. For the second entry I entered 40 as the Quantity to account for the 40 feet of installation that had the increased level of difficulty because of the 25′ ceiling height and narrow confines. Since the material was already accounted for in the first line item I deleted the material cost from the second so it wouldn’t extend out in the calculations. Essentially I’ve charged twice as much for the labor on the high section of crown.

Trim Installation
Cost Worksheet

	Qty	Unit	Matl Cost	Matl Ext	Labor Cost	Labor Ext	MHrs	MHrs Ext
Crown, stock pine, 11/16" x 4-5/8"	200	LF	$2.10	$420.00	$1.24	$247.68	.036	7.2
Crown, stock pine, 11/16" x 4-5/8"	40	LF	–	–	$1.24	$49.53	.036	1.4
Cost Totals				$420.00		297.22		8.6

As an aside while doing this "chunk" of the estimate I knew that the material budget line cost for the crown in this case was different from what I was actually going to be getting. The $2.10 per foot was for a stock clear crown and I was getting some pre-primed finger-jointed pine from Home Depot for just $.89. For such a small project I didn’t bother with making the change in the price. I was installing a painted finished final product so since either material would meet the performance specification I let slide and decided the company would earn the excess on this project knowing full well that somewhere sometime in the future I will estimate short and that excess will help cover that in the future.

While there is 1% figured for Contingency in my company’s Overhead Markup I’m sort of padding that Contingency a little further with that $242 dollar difference knowing that the slightest little thing can turn such a small project like this into a money loser.

On a larger project I probably would have made an adjustment for the change in the materiel from the Cost Book Item to what I was actually using. Regardless of that I still however would have specified in my proposal that I was using FJ trim and not have represented it as clear pine.

The carpenter actually doing this installation in this particular case is not the same Carpenter-B @ $56.80 per hour that I used to set-up the job. I’d be sending a Carpenter-A @ $79.40. That’s because the total lineal footage of the project should be able to be done in 8.6 MHrs meaning it was a one day project for one guy. If it had been a sixteen hour project I might have sent two Carpenters either an A-B combination or a B-B group but I wasn’t going to do that for just an 8-1/2 hour project. The A-B or B-B group probably could have done it all in just 4+ hours but then they would have to travel to somewhere else for the rest of the day and that wouldn’t have been as efficient a use of their time.

I was doing the project in oil paint so I needed the overnight for any touch-ups to dry. As part of the "Work Orders for this "chunk" would have been instructions to fill nail holes and caulk as required so that on a final visit the whole thing can be Touched-Up or another coat of paint applied. In other word get as much done as possible so the remaining tasks to finish the project can be kept to just one trip.

---

3. Painting (final touch-up) and Takedown/Close-out
For the final coat and touch-up and clean-up I’ve got that same Carpenter-A @ $79.40 who did the installation going back there again to: apply a final coat > fix any problems > clean-up > present the bill and pick-up a check > then return clean brushes and put away any tools and equipment that he or she wouldn’t need for the next project. I budgeted that at five hours knowing that it would probably take three maybe four.

Painting & Takedown Worksheet

	Matl		Labor		Total	MHrs
Costs		$0.00		$240.50	$240.50	5
Markups	35%	$0.00	65%	$156.32	$156.32
Price		$0.00		$400.00	$400.00	5

 

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The Complete Project Summary
Okay someone is going to say that I didn’t include the cost of the paint putty and caulk anywhere in my estimate and that’s sort of true. That paint, the Benjamin Moore White Metal Wood Enamel, is something that we use on all our woodwork as kind of the default primer/paint ( it’s self priming and builds up fast so I really like it a lot). We buy it and the other stuff caulk and putty by the case in bulk and not by the project. Since I knew I was over estimating the cost of the trim I knew I was covering the costs of those materials and still making the contribution to the Cost of materials account that any materials would be credited against.

Project Summary

	Matl		Labor		Total		Time
	Cost	Price	Cost	Price	Cost	Price	MHrs
Costs			$172.00	$280.50	$172.00	$280.50	5
Markups	$420.00	$570.00	$297.22	$490.00	$717.22	$1060.00	8.6
Price			$240.50	$400.00	$240.50	$400.00	5
	$420.00	$570.00	$709.72	$1170.00	$1129.72	$1740.00	18.6

While that’s just the way that I would have done the estimate for this project I’m really entrusted in getting some feedback on the pros and cons of the technique and my thinking. While it took a couple of hours to write out this explanation of just how I did it it actually took just 15 minutes to do the actual estimate either entering or looking up all the data in my estimating system. The extimate numbers and client information are automatically entered in to a Contract form so the only thing I had still remaining to do was to tweak the payment schedule numbers however I wanted them to appear. Probably $600 with the $1140 balance due on completion.

Comparing the Traditional Volume Based Markup
vs.
a Capacity Based Markup Methodology
(aka a PROOF/Indexed/Labor Allocated Markup Method)

I recently got up one morning and checking the Journal of Light Construction homepage I spotted something under the “New This Month” section that said “Business-Allocating overhead to labor” and clicked on it and was happy to find an article Allocating Overhead to Labor Makes Financial Sense by Irv Chasen’s the founder of PROOF Management consultants. Personally I took a seminar course back in 1987 called “How to Survive & Prosper in the Contracting Market” where Mr Chasen taught his method of markup which allocates overhead recovery to labor and it completely changed and rescued me from the way I was doing business beforehand.

One of things I always liked about Mr Chasen presentation of his methodology back in 87 that he makes infers again in his article is that applying markup isn’t about just arbitrarily applying a number, it’s about approaching the recovery of overhead SCIENTIFICALLY! It’s not about using a number like the “magic 1.67″ we always seem to hear it’s about a SCIENTIFIC METHOD for determining what the correct number is and how that number to the correct index.

The paragraph I think that is key to beginning to understanding the strength in a Labor Allocated Overhead methodology and related to my own experience is where he writes: “Builders often allocate overhead by adding a percentage to labor and material combined. This may work well for some companies, particularly when the labor-to-material mix remains about the same on most of their jobs. However, more often than not, this will not hold true. Typically, relating overhead to labor and material combined can produce mixed results, while recovering overhead as a percentage of labor alone is far more accurate.”

Since I was already working on developing examples of the potential problem using a traditional volume based markup can cause as part of something else I’ve been working on I thought I’d publish a few examples and explore to two methods further. The scenario I’ve created to explain the potential problem while hypothetical is based on what happened to me in my own real life situation when I first started on on my own in the contracting business back in 1985-87 so take heed it can really happen in real life and the symptoms and effects of the problem are probably diagnosed and attributed to other factors more often than not.

Part 1- The Potential Problem Using a Traditional Volume Based Markup

Click to download the Excel Spreadsheet that was used to model the scenarios in this paper. (Windows & Macintosh)

Lets say my buddy an I have been working for several years for this one company and one day our boss tells that he’s planning on closing up shop and retiring within the next year so he tells this so we can make plans. We decide we’ve really enjoyed working together so we decide to start our own company when our boss finally closes down and we use our time left to create a pro forma plan of what we are going to do and what we are going to charge for it.

We’re going to pay ourselves $25 per hour which works out to $1000 per week or $52,000 per year. With burden it comes to a cost of $30.50 per hour ($1173.11 per week per person and $2346.23 for two people) or approximately $10,167 per month in labor costs for the two of us.

We want to keep on doing what we’ve been doing for years so we decide the projects we are going to do are are nice custom architectural woodworking installations. All hardwood molding and cabinets. Cherry, mahogany and a little bit of oak. Based on the finish carpentry projects we’ve done in the past with our old boss we’ve figured out that for every dollar spent on the Cost of Production Labor there is approximately $1.56 spent on materials. That means for the $10,167 of Production Labor Cost each month we should expect to see a $15,860 of Material Costs

Next we set out to figure out what our Overhead Costs are going to be,

While we have some work lined up to get us started to generate new leads we’ve given ourselves a monthly budget of $600 ($7200 per year) to advertise in the local news publications and home and garden magazines.

We plan to compensate ourselves for our estimating and sales efforts with $900 dollars each per month for a monthly budget of $1800 ($21,600 per year).

We going to hire a daughter who’s a recent college graduate for $1600 a month to answer phones and take care of the books. We’ll rent a small space in an industrial complex where we have about 750 SF of space to park a truck or use as small shop and 150 SF to run our office out of for $825 per month ($12,000 per year). We have budgeted $900 per year for our Office Equipment, $600 per year for our Telephone service, $3240 for our Computer Expenses, and $70 per month ($840 per year) for our Office Supplies.

We’ve have a budget of $900 per month to cover the payments, maintenance, and fuel for our two vehicles. Since my partner and I are going to be doing all the work ourselves we have not created a budget figure for Job Supervision. We have created a month budget of $550 ($6600 per year) to maintain our existing tools and purchase any new ones. We have a yearly Service & Callback budget of $1200 to handle any problems that might come up. We figure $140 per month to cover our Mobile Telephone service and nothing for Pagers since our Mobile Telephone service has that service built into their plan.

We plan to compensate ourselves each $900 per month as an Owners Salary for the general administrative chores we will have to do in addition to the on the job labor we’ll be performing. Our General Insurance will run $9600 per year. We plan to sock away $1200 per month to build up an Operating Cash Reserve Account (O.C.R.A.). We have planned a budget of $245 per month for Interest. We have a planned budget for $600 per year for our local county and town taxes. We have a budget of $900 per year to cover for any Bad Debt. $900 for all our Licenses & Fees. We’ve set up yearly budget figures of $2160 and $2040 respectively for Accounting and Legal fees. We’ll budget $12,000 per year for Education & Training, $275 for Entertainment, and $1800 per year for Association Fees.

Plugging them all into a spreadsheet we get something that looks like this:

Overhead Costs
Overhead Item	Per Month	Per Year
Advertising	600	7200
Sales	1800	21600
Office Expenses
Staff	1600	21600
Rent	825	12000
Office Equipment	75	900
Telephone	50	600
Computer Expenses	270	3240
Office Supplies	70	840
Job Expenses
Vehicles	900	10800
Job Supervision	0	0
Tools & Equipment	550	6600
Service & Callbacks	100	1200
Mobile Telephone	140	1680
Pagers	0	0
General Expenses
Owners Salary	1800	21600
General Insurance	800	9600
O.C.R.A	1200	14400
Interest	245	2940
Taxes	50	600
Bad Debts	75	900
Licenses & Fees	75	900
Accounting Fees	180	2160
Legal Fees style="mso-spacerun: yes">	170	2040
Education & Training	1000	12000
Entertainment	275	3300
Association Fees	150	1800
TOTALS	$13,000	$156,000

 

We plug all those numbers (Monthly Labor Costs, Monthly Material Costs, and Overhead) into a table and we decide well add $4400 per month for profit (which works out to be equivalent to 10% of Sales) so at a that should net us $52,800 in profit at the end of the year that we can split between us or reinvest in one way or another.

 

Our Pro Forma Financial Projections
	Labor Costs	Material Costs	Total Direct Job Costs	Overhead	Total Costs	Sales	Profit
Typical Per Month	10,167	15,860	26,027	13,000	39,027	43,427	4,400
as % of Sales	23.4%	36.5%	59.9%	29.9%	89.9%	100.0%	10.1%

We extend those numbers out over the year and we get a spreadsheet that shows us our anticipated results below

Our Pro Forma Financial Projections
Year 1	Labor Costs	Material Costs	Total Direct Job Costs	Overhead	Total Costs	Sales	Profit
January	10,167	15,860	26,027	13,000	39,027	43,427	4,400
February	10,167	15,860	26,027	13,000	39,027	43,427	4,400
March	10,167	15,860	26,027	13,000	39,027	43,427	4,400
April	10,167	15,860	26,027	13,000	39,027	43,427	4,400
May	10,167	15,860	26,027	13,000	39,027	43,427	4,400
June	10,167	15,860	26,027	13,000	39,027	43,427	4,400
July	10,167	15,860	26,027	13,000	39,027	43,427	4,400
August	10,167	15,860	26,027	13,000	39,027	43,427	4,400
September	10,167	15,860	26,027	13,000	39,027	43,427	4,400
October	10,167	15,860	26,027	13,000	39,027	43,427	4,400
November	10,167	15,860	26,027	13,000	39,027	43,427	4,400
December	10,167	15,860	26,027	13,000	39,027	43,427	4,400
Yearly Total	122,004	190,320	312,324	156,000	468,324	521,124	52,800
as % of Sales	23.4%	36.5%	59.9%	29.9%	89.9%	100.0%	10.1%

 

Looking at that pro forma plan we can take $522,820 in pro forma Sales and divided it by the $312,320 in anticipated direct job costs and we get a figure of 1.67 that we can use. If we take our estimated Direct Job Costs for any one particular project on it own and multiply it by 1.67 will get the desired Sales price that will cover our Overhead and earn the Profit we want. In fact that 1.67 markup is the same markup that we see so many trade industry consultants recommend we use to achieve a desired %40 Gross Profit margin.

Total Direct Job Costs	Markup	Sales
$312,324	1.67	$521,124

---

Total Direct Job Costs	Gross Profit (OH + Profit)	Sales
$312,324	$208,800	$521,124
%59.9	%40.1	%100

 

So we start off on our first year in business for ourselves. The first two months, the first two projects come off without a hitch and are true to our pro forma predictions. The next two months of projects are just like the first two except instead of cherry, mahogany and oak our clients decide they want painted woodwork and cabinets so instead of billing for $15,860 of materials we’re only billing for $11,102.

Starting that May we get a gig working for a GC that will have us doing the finish work for 8 houses for him and that should carry us through the rest of the year without us having to look for anymore work until we’re done with them only the GC and the architect, since they will be personally working with the home buyers on their product selections, will supply all the major materials such as interior doors and cabinets. We only have to supply the base, crown, casing, and general moldings and the fasteners we want to use such as nail and screws.

Our first thought it great! we no longer have to deal with the hassle of getting those materials. There no crimp on our cash having to extend money our of our pockets for materials until we get paid for them but another problem soon becomes evident. That reduces our Material Costs to 40% of what we would have gotten had we been providing all the materials.Not having those Material Costs to “markup” on we no longer have those markup dollar contributing to our Overhead expense which has remained a constant $13,000 per month.

Actual Year 1	Labor Costs	Material Costs	Total Direct Job Costsb Costs	Overhead	Total Costs	Sales	Profit
January	10,167	15,860	26,027	13,000	39,027	43,427	4,400
February	10,167	15,860	26,027	13,000	39,027	43,427	4,400
March	10,167	11,102	21,269	13,000	34,269	35,488	1,219
April	10,167	11,102	21,269	13,000	34,269	35,488	1,219
May	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
June	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
July	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
August	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
September	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
October	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
November	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
December	10,167	6,344	16,511	13,000	29,511	27,549	(1,962)
Yearly Total	122,004	104,676	226,680	156,000	382,680	378,224	(4,456)
as % of Sales	32.3%	27.7%	59.9%	41.2%	101.2%	100.0%	-1.2%

 

In the end our Net Profit figure shows a loss! The result falls $57,256 short of our expectations ($52,800 pro forma profit + the $4,456 loss). Instead of taking part of that $52,800 and splitting it with my partner to supplement the wages we paid ourselves we now have to did into the paychecks we paid to ourselves to pay out of pocket for our operational loss.

Part 2-The Solution Dealing With the Problem using a
PROOF/Indexed/Labor Allocated Overhead methodology.

Dealing with the same numbers as the we used in the previous example my buddy and I are going to use a PROOF/Indexed/Labor Allocated Overhead methodology as Irv Chassen talks about in Journal of Light Construction Article Allocating Overhead to Labor Makes Financial Sense, instead of the Traditional Volume Based Markup. (Mr Chassen was the founder of PROOF Management Consultants hence the reason why the method is often referred to just as PROOF in the building and remodeling community)

We again have all the same baseline projections as we did in our initial pro forma planning.

Our Pro Forma Financial Projections
	Labor Costs	Material Costs	Total Direct Job Costs	Overhead	Total Costs	Sales	Profit
Typical Per Month	10,167	15,860	26,027	13,000	39,027	43,427	4,400
as % of Sales	23.4%	36.5%	59.9%	29.9%	89.9%	100.0%	10.1%

 

Looking at the same set of projection numbers again instead of taking the sum of Labor Costs and Material Costs and then multiplying that number by a markup figure to achieve our desired selling Price we going to come up with a different markup multiplier that will work off of just our Labor Cost (since our Labor Cost for all intents and purposes stays the same or stays within the range of what’s called Common Cause Variation) month to month.

For a second lets ignore the Material Costs figure all together. We are still going to work just as hard, the same amount of hours and we’ll still want to pay ourselves the same so the labor costs remain $10,167. We also still want to make the same $4,400 per month in Net Profit and our Overhead is still going to be the same $13,000. Looking at it from a different perspective now our Labor Cost can be seen as representing %53.1 of sales and that same desired Net Profit of $5000 per month now represents %23.4 of Sales.

Our Pro Forma Financial Projections Ignoring Material
	Labor Costs	Total Direct Job Costs (no materials)	Overhead	Total Costs	Sales	Profit
Typical Month	10,167	10,167	13,000	23,167	27,567	4400
as % of Sales (with Labor only, no Material Costs)	%36.9	%36.9	%47.2	%84.0	%100	%16.0

 

If I take the new Sales figure of $27,567 and divide it by the $10,167 Labor Cost we come up with a new markup figure to use of of 2.71. If I multiply any estimated Labor Cost figure by 2.71 it will return me a number that then covers our Overhead and earns us our desired Profit proportional to the estimated Labor Cost.

We can now extend out our pro forma predictions for the coming year like this:

Our Extended Pro Forma using a PROOF/Indexed/Labor Allocated Overhead methodology.
Year 1	Labor Costs	Total Direct Job Costs	Overhead	Total Costs	Sales	Profit		Material Costs		Total Volume
January	10,167	10,167	13,000	23,167	27,567	4,400	+	15,860	=	43,427
February	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
March	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
April	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
May	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
June	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
July	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
August	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
September	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
October	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
November	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
December	10,167	10,167	13,000	23,167	27,567	4,400		15,860		43,427
Totals	122,004	122,004	156,000	278,004	330,804	52,800		190,320		521,124

 

In this same table now using a different markup system we’ve still achieved the same total volume figure as we did using the Traditional Volume Based Markup (click to jump back to see the Traditional Volume Based Markup table) And perhaps even more importantly we separated achieving our Overhead and Profit figures from any dependency on selling a particular volume of materials. If we don’t sell any Materials at all we will still completely cover our overhead and earn our desired profit!

However in his JLC article Mr. Chassen when giving his example of company using the PROOF methodology mentions

” Remember as you read this that we are discussing only overhead recovery, and that all costs — labor, materials, and overhead — should also be marked up for profit.” (my emphases)

In the example above we already marked up our Labor and Overhead for profit while ignoring materials and selling them at their literal cost. We could however then apply a discrete and separate Markup on the Materials segment of the project This is also more in line with the thinking behind Activity Based Costing methodologies. Activity Based Costing is form of cost accounting that focuses on the costs of performing specific functions (processes, activities, tasks, etc.) rather than on the aggregated costs of the organizational unit or company. ABC generates more accurate cost and performance information since it related more specifically a particular costs associated with a specific product or service.

In other words a markup figure that would be applied independently to any Materials Costs would reflect the costs associated with procuring the materials. If you could arrange to have all your materials delivered by you supplying lumber company you could perhaps just use a markup of %6 for a Net Profit. In my companies we haven’t been able to do that since we often have to go to our hardwood supplier and pick out our wood based on grain patterns and appearance but after studying how much time we spent selecting our own material we found it came to %9 of the Cost we paid for materials so we apply a 15% markup on any Materials we supply for a project (%6 + %8 = 15%).

Now using this method if we do sell Materials we earn an additional Net Profit on those materials while also covering our typical costs associated with procuring the material! (note-In the cases where the costs associated with acquiring materials stray out of the realm of “typical” an into extraordinary such as they need to be shipped FedEx from Sweden we plan for and bill for those charges as Direct job Costs).

Part 3 – Summing things up.

What makes the PROOF/Indexed/Labor Allocated Overhead methodology a better choice as a markup strategy over the traditional volume based markup method so many of us first learned is that it isolates and protects a company’s recovery of Overhead Costs and ability to generate a Profit from the fluctuations and variations in the amount of Material and Subcontractor Costs in a project and instead ties Overhead recovery and Profit generation to the much more reliably predictable Internal Labor component (which while expressed here as Labor Cost it can also be expressed as Time).

Interestingly I recently found in the automobile service industry the methodology isn’t called PROOF, it’s referred to “indexed” markup. I’ll infer that that’s because the rate for overhead recovery is based on or “indexed” to the the billable hours that a mechanical shop can perform in a year.

From what I’ve gathered through some consulting I’ve done with an small aerospace defense job shop contractor 99% of the companies involved in that industry also practice the same methodology although its not given any special names there, it’s just the way it’s done. Why? Because of essentially the same problem I mentioned above with regard to materials. When an aerospace contractor works on a government contract all of the materials are supplied by the government so they can’t mark it up for overhead and/or profit. Those aren’t small businesses at all and they are a lot more complicated and sophisticated than we in the building and remodeling industry so the “doesn’t work for larger contractors” argument fails on that count.

Part 4 – Getting You Own Company Setup with a PILAO (Capacity Based) Type Markup

We’ve developed a freeware Microsoft Excel
Based Spreadsheet that helps contractors determine what labor rates to set based on what their Fixed and Variable Overhead Costs actually are anyone can download, use, and modify it by visiting the freeware section of our 360Difference.com software site (The PILAO Worksheet – PILAO_Wksht v9.xls ).

Part 5 – Other articles discussing the use or application of a PROOF/Indexed/Labor Allocated Overhead methodology.

	Journal of Light Construction September 2002 How To Charge For Overhead By Les Deal   An Iowa based remodeler explains how he has successfully practiced using a PROOF/Indexed/Labor Allocated Overhead methodology for over 20 years.
	Journal of Light Construction March 1998 A Simple System for Turning a Profit By Jim Zisa   Jim Zisa of West End Woodworks in Winston-Salem, N.C., explains how with only so many billable hours in a year available for us to work by including overhead and profit in our labor charges, a small construction company can ensure that all its costs are covered.