If correct, it will help you absorb a high percentage of your overhead.
Let's recap just a bit. A few months ago we talked about why most companies go out of business. The number one problem was improper labor pricing with the number two problem being cash flow. Our objective, beginning with the February article, was to walk you through the same process we use in our full-day seminars to help you determine what you must charge to cover your real costs of doing business while generating the profit you desire.
The first month we discussed equipment replacement costs. We found that equipment replacement costs were normally your second highest cost of doing business in the entire company. Last month we discussed your highest cost of doing business, nonbillable time. We found that average nonbillable time for installers was 20-35 percent while nonbillable time for service techs ran 40 to 55 percent of their total time. Hopefully by this point you have filled out the first two worksheets and are ready for this installment which deals with material markups.
All of our materials tend to fall within two main categories which are materials and/or equipment used during installation and materials and/or parts used while performing service work. The first question we need to answer is: What part do materials play in your business? That is, do they basically pass through with very little markup and minimum gross profit or is there significant markup and therefore significant gross profit.
That may sound like a silly question to the plumbing companies reading this article, but it isn't to some other trades. Painter's material and/or equipment is paint. The typical painter can buy paint for 10, 15 maybe 20 percent less than you and I can. They have some profit, but not usually enough "extra" profit to absorb much, if any overhead. That is not the case in our industry. In our industry we have significant markup and significant gross profit. Typically we markup our equipment and materials for an installation job somewhere between 25 and 50 percent. When it comes to parts, the markup is even higher. We should be averaging at least 100 percent for all our spare parts. Smaller items valued at 50 cents to say $5 or $10 dollars you probably markup two, three or four hundred percent. Larger items, say $25 or $50 dollar items we markup up 50 percent or 75 percent, but when it is all said and done we should be averaging at least 100 percent for all of our spare parts. Markups of this magnitude can, and will, absorb a significant amount of our overhead.
The common question is: "Why do we have to use profits from our material sales to absorb overhead? Why not let labor absorb it all?" That is a good question. The answer is that the ideal situation is for labor to absorb all of our overhead. If we did that, it would give us a lot of flexibility in how we priced a job and any profit we made on materials and/or parts would be just that-profit. That can be done, but not very often. Although I have seen companies who controlled costs to the point they were able to absorb all their overhead with labor dollars, they are few and far between. Normally a company is forced to subsidize labor cost with material profits to keep their labor rate within reason. The exception, however, would be to switch to flat rate pricing.
One of the beauties of flat rate pricing, as we are all aware, is that the customer never sees the hourly rate. Although there are limits, the opportunity to put all your overhead on labor can be a reality with flat rate pricing. Let's take an example.
Total billable hours = 5,000 hours Total material cost = $250,000 Average material markup = 35%
Gross Profit on materials: $250,000 x 35% markup = $87,500
That means materials would normally absorb $87,500 of overhead cost. If we decided to let labor pick up "all" the overhead it would have to pick up the $87,500 also. If we take the $87,500 and divide it by the 5,000 billable hours we find the company would have to increase its hourly rate by $17.50 per hour ($87,500 / 5,000 billable hours) if labor were going to absorb all the overhead costs. Could you make that kind of increase in your hourly rate if you charged by the hour? Perhaps, but it is a relatively simple thing to increase the "internal" hourly rate by $17.50 if you are on flat rate pricing. If you suddenly increased your hourly rate by $17.50/hour your customer would probably notice it and may, or may not, say something about it. With flat rate pricing the probability of your customer noticing you made a change in your "internal" rate is pretty slim.
Although most of us would like to put all the overhead on labor we are going to assume the norm, the norm meaning we will absorb overhead with materials and direct labor. Now it's time to fill out Worksheet #3.
Cost of materials $ __________ Plus average markup on materials + $ __________
Total materials (cost plus markup) = $ __________
Since many reading this article will do installation and service, the following modified worksheet might be better. You'll notice it breaks material costs down between installation and service. This form may be a lot simpler since it allows the user to use the distinctly different markups for each department. Once filled in, then simply add the columns and you will have the same figures as you would have had with the above worksheet.
Worksheet 3 (modified) Material Cost + Markup = Total
Installation $ _______ $ _______ = $______ Service $ _______ $ _______ = $______
Totals = $ _______ $ _______ = $______
Filling out of the first three worksheets may not seem to make a lot of sense at this point. What is happening is that we are creating building blocks. First we created the Equipment Replacement block. Next we created the Cost of Nonbillable Time block. This month we created the Material block. Next month we will look at the Cost of Matching Taxes. When we have created all the blocks we'll put them all together and will then know what our total costs of doing business is. Once we know our total cost of doing business it is a very simple and quick process to determine our hourly rate.
The worksheets reprinted in the articles are the same ones used in the full-day seminar/workshop called "Product and Service Pricing for a Profit." Contractors can purchase the manual ($35) used in the seminar and/or the user friendly software program ($199.95) to model your company to tell you what to charge per hour.
"This article was originally posted on ww.reevesjournal.com."