Introduction

Through out the web you’ll find blurbs from 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. under the same circumstances.

Article Navigation

• Introduction
• Article Navigation
• 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
• Get Help Figuring Out Your Company’s Markup

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 .

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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).

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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.

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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.

1. A Project with Labor, Materials, and SubContracting in the Same Ratio That Used in the Markup Planning Process 
2. A Project with a Low Relative Cost of Labor to High Cost of Materials, and SubContracting and…
3. A Project with High Relative Cost of Labor to Low Cost of Materials, and SubContracting

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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 lose 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 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 buy David Gerstel’s 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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