What Can We Learn From This Chart?

I went around to a several of the online construction forums to see who would pick up on what the chart was telling us and while a couple of folks did pick out the significance my friend Bob Kovoacs who moderates the Estimating & Markup forum on the JLC Online web site perhaps summed it up best:

I think we can gather that labor costs and overhead costs stay rather consistent from month to month, whereas the other costs vary greatly from month to month. Seems like a good reason to tie (allocate) overhead costs to labor costs, rather than to total volume.

Exactly my point and one of the best arguments for using a Capacity Based Markup methodology over a methodology based on your Sales Volume. Your internal labor costs which are a true measure of your company’s capacity for work in a year correlate almost exactly with your companies direct overhead costs. The most prominent driver of your company’s overhead costs are people, your personnel, working and not the dollar value of the materials they install or the subs working on your projects.

While one contractor noted that the Total COGS (Total Cost Of Goods Sold) had something of a correlation with the materials line a higher variation in the sub contracting cost line would have thrown that correlation off.

For me the only significance I could draw from the Materials line being similar to the Cost Of Goods Sold line (COGS) is that that Materials sales can be seen as a Driver of the Total COGS. If you are contractor using the Total Volume Based Markup Method (like Michael Stone advocates in his books Markup & Profit & Markup & Profit Revisted) that’s a big huge important deal to consider. You then absolutely have to work at selling Materials (and subcontracted work) as part of your projects to cover your Overhead Cash Flow expenses and any Labor only, or high Labor to Materials ratio work you may get will hit you hard in the pocket book (see Comparing Markup Methodologies In Real Some World Pricing Scenarios here)

On the other hand if you are a contractor using the Capacity Based Markup method (like David Gerstel describes on pgs 167 through 168 of his book Running a Successful Construction Company where your Overhead Recovery is tied only to your Labor Costs you say “big deal”, or “so what”. Material sales are just gravy or icing on the cake (in that you can earn a Net Profit on them) but they aren’t at all important as far as recovering your Overhead Costs.

I thought this graph perfectly illustrated the reasoning as to why contractors should tie their markup to their labor costs (Capacity Based Markup) rather than tying it to the total volume of Cost Of Good Sold because that number varies to much to match the consistent line of Overhead Costs that contractors face month to month. My friend Jim whose company this chart was based on, uses a Loaded Labor Rate built using Capacity Based Markup so he doesn’t have any problem hitting hitting his Overhead Cash Flow requirements but if 2009 were to follow the same trend lines of 2008 and he was to use a Volume Based Markup like what is written about in Michael Stone’s Markup and Profit and like so many of us are first taught he would have Cash Flow shortfalls the first four months of the new year and wouldn’t get caught up until the fifth month when the summer outdoor season really picks up (and his projects sell lots of materials).

With any stable company that isn’t hiring and firing people all year long the labor cost line is going to remain relatively stable and consistent month to month. What drives the changes in the Materials and SubContracting lines is the changes in project mix for this particular company. If you take the SubContracting and Material costs out of the markup computation equations you are left with the Labor Cost component which is relatively stable and almost perfectly parallels the Overhead requirements. So,…. for those that are interested the lesson is you should tie your markup multiplier to Labor Costs alone (not COGs) to properly allocate Overhead Costs. (see Irv Chasen’s free JLC January 2004 article Allocating Overhead to Labor Makes Financial Sense).

In this case the company is a four carpenter general all around carpentry contractor but in the spring summer and fall they have an excellent deck business that really picks up for them and when the winter season takes over the outdoor work which is their bread and butter scales down and they go inside. The subcontracting they do is mostly for deck and outdoor lighting and little bit of plumbing for hot tubs and moving hose bibs.

The costs lines that are variable Materials (red) and Subcontracting (magenta) do trend down and in fact continue down through the tough winter months of January and February and that is because hey get more service and maintenance type projects in the winter months which have a higher ratio of Labor to Materials. And while it isn’t anything you could necessarily pick up from looking at the graph I also happen to know to first hand that two of the jobs they did late January and February of last year were labor only interior finish subcontracts to a Kitchen & Bath studio where the K&B studio supplied all the materials.

I’ve got an Excel workbook that I used to generate this chart that I try to work on hopefully sometime this weekend or possibly early next week and publish a link here to it here so everyone can look at it and see just how bad that Cash Flow shortfall really is. I think a lot of people will be shocked to see just how bad it is.

I’ve produced some spreadsheets in both Apples Numbers and Excel (and PDF that has none of the functionality by illustrates what I’ve written about here) that you can download to play with the data yourself to model different scenarios to see what happens to overhead recovery using the two different markup methodologies..

CBMvsVBMInADownturn.zip

CBMvsVBMInADownturn.xls.zip

CBMvsVBMInADownturn.pdf

• Introduction
• The Story Begins
• Part 1 – Labor Costs
• Part 2 – Fixed Overhead Costs
• Part 3 – Net Profit and Determining the Selling Price for a Job
• Part 4 – Comparing The Two Different Methods in Practice
• Job #1 – A Project with Labor, Materials, and SubContracting in the Same Ratio That Bill Used for Planning.
• Job #2 A Project with Low Relative Cost of Labor to High Cost of Materials, and SubContracting
• Job #3 A Project with High Relative Cost of Labor to Low Cost of Materials, and SubContracting
• Conclusions
• Footnotes
• Further Reading & Tools

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.

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.

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.

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.

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.

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).

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

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:

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.

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.

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.

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

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.

Further Reading & Tools

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.

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.

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.

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

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.

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’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 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