Last month's column, "I want a breakdown," brought an unusual amount of response via mail, telephone and the Internet.
Respondents included not only PHC contractors but general contractors, architects, CPAs and other entrepreneurs who were not associated with our industry.
The article dealt with how to deal with customers with price complaints who insist on getting a time-and-material breakdown from flat rate companies. My basic advice was give them what they want. Except make sure it is thorough and complete. Don't just factor in broad concepts of time and material. Also show how overhead factors into job costs and go into detail about how much overhead goes into your selling prices. It gives you a chance to dispel the butt-crack, money-hungry image portrayed of our industry in TV commercials. A cost breakdown reminds them that they are dealing with a credible company.
What surprised me was the number of respondents from outside our trade. What piqued my interest was how my column got into their hands.
Mysterious Selling PriceIn most cases, they called to take issue with the selling price I had calculated for a sample job with a total job cost of $237.79 and a desired net profit of 20 percent. What I again verified in my mind is that ignorance is not an exclusive characteristic of the PHC industry but that other entrepreneurs experience the same glaring shortcoming. There are thousands out there who don't understand simple numbers crunching. I spent no less than 50 hours on the phone trying to explain fundamental business math to callers.
For instance, a general contractor from San Francisco got a copy of the article from his plumber. The GC was screwing the plumber when the plumber submitted breakdown bills for extra work. The GC made the common mistake of multiplying job cost by the profit percentage. In other words:
(Wrong arithmetic): $237.79 X .20 = $47.56. This then gets added to $237.79 to derive an incorrect selling price of $285.35. This is the fundamental error made by at least 90 percent of the people who come to my seminars.
Most of the people who called or commented on my column couldn't figure out how I got a selling price of $297.24 from the job cost and profit percentages used. One participant in the online Plumbers Discussion List even accused me of holding back so that I could generate seminar income.
Time For A ReviewThis tells me that it's time for a review of the basic arithmetic that goes into calculating a selling price. It's the subject I wrote about in my very first PM column way back in April 1987. Let's review it using not my simple sample problem of $1,000 in direct labor and material costs and 15 percent desired net profit. Instead, let's use the numbers from last month's column that sparked all the inquiries.
For those who calculated an incorrect selling price of $285.35, keep the following facts in mind from now until you cash in your chips:
1. Selling Price always equals 100 percent. Here lies the fundamental root of all mistakes. When you figure profit as a percentage of Direct Cost ($237.79 X .20), you are cheating yourself out of the higher price to which you are entitled.
2. Direct Cost usually includes the following: material, permits, labor. Individually and collectively, the dollar amounts are a percentage of the Selling Price.
3. Gross Margin is the difference between Direct Cost and Selling Price.
4. Overhead (or Indirect Costs) consists of everything that is not a Direct Cost. This includes everything from utility bills to advertising expense to administrative salaries, etc. Individually and collectively, these dollar amounts also are a percentage of the Selling Price.
5. Net Profit is the number of dollars left after subtracting Overhead dollars from Gross Margin dollars.
Mathematical Language: Again, remember that Selling Price equals 100 percent. Job Cost ($237.79) represents a certain percentage of the Selling Price, i.e., the percentage not represented by Net Profit.
Net Profit, in last month's example, we figured as 20 percent. That's 20 percent of the Selling Price, not of Direct Cost. So if Net Profit is 20 percent of the Selling Price, Direct Cost must be 80 percent. So É
A. $237.79 (Job Cost) = 80 percent of X (Selling Price).
B. $237.79 = .80X (a simple algebraic formula).
C. $237.79/.80 = $297.24 Selling Price.
Selling Price $297.24 or 100%
Total Job Cost $237.79 or 80%
Net Profit $59.45 or 20%
Yes, there are markup tables you can use as a shortcut. For instance, in this case, a markup multiple of .25 (25 percent) multiplied by the Direct Cost of $237.79 will give you $59.45, which, when added to the Direct Cost, achieves the correct Selling Price of $297.24.
There's nothing wrong with using markup tables or any other shortcuts, as long as you understand the fundamental mathematical principles involved. What you should remember:
- Selling Price always equals 100 percent.
- To find Selling Price when you know Direct Cost, you must divide the Direct Cost by a decimal fraction, not multiply by a fraction.
- That fraction will be what's left after you subtract the Net Profit percentage, expressed as a decimal fraction (.20), from the 100 percent (1.0) representing Selling Price.