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

(Originally posted in February of 2004) 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 (Volume-vs-Capacity-Markups_v3.xls) that was used to model the scenarios in this paper. (Windows & Macintosh)

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:

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.

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

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.

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.

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.

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.

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:

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. 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 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 Capacity Based Markup Worksheet  page on our 360Difference.com software site.

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.