Re-think labor costs, production measurements and selling prices to find the right compensation plan for your business.

Last month, Sam, a fictitious contractor, was trying to balance rising overhead costs with his commission-based compensation system. He finally decided to shield some overhead costs from the sales commission, but that met a less-than-warm welcome from his service professionals. He needed a simple way to compensate excellent performance without driving his selling prices through the roof.

Below is a plan I recommend for Sam, and it might work for you, too. First of all, we have to re-think how we apply our cost of labor. A common practice among service contractors is to define job cost as labor plus materials. Overhead and profit is then covered by the gross profit margin, which requires gross margins to exceed 60 percent in some cases.

Mathematically, this format works just fine, but in jobs that include a lot of materials or expensive fixtures, the final selling price tends to become a huge hurdle. Managing to a gross profit margin also requires contractors to think in terms of gross sales rather than total production.

If you’ve been in the service business for long, you know that “nonbillable” time accounts for about half your service employee wages. If that’s the case, then why not consider service professional wages as part of overhead, rather than direct cost?

Here’s how it works: It doesn’t matter whether you’re paying by the hour or by commissions; first determine what you realistically consider to be “base” pay for your service professionals. Whether you pay by the hour or by commission, budget for a realistic annual base wage. If you expect to pay $30 per hour, with occasional overtime, then budget for $70,000 or so. If your average commission earner should earn about $75,000 per year, then use that number. Don’t include bonuses in this part of the budget, but be sure to include your employer expenses such as worker’s comp, your benefits package, FICA matching, etc.

Next, decide on an increment for measuring your production. I like to use 1,000 production units per year because it’s a simple number and can loosely be translated to 50 percent billable efficiency, which many contractors understand. (Check out my earlier columns in Plumbing & Mechanical’s online archives for “value points” to see more on this topic.) With service tech base wages included in overhead, you simply divide your total overhead (which will include wages) by the budgeted production units (in our example, it would be 1,000 production units per service truck). This gives you your cost per production unit, including labor costs, which you can use to calculate a selling price.

To figure a selling price, instead of using a high gross margin, use a net profit margin that’s closer to your actual profit goal. For example, if your goal is to net 25-percent profits before taxes, then consider using a net profit margin of 30 percent or so.

Whether you pay by the hour or by commission, your base wage expenses shouldn’t exceed your budgeted wage expenses as long as you keep productivity within budget. For example, if you budget for 1,000 production units per year and you’re averaging 4 units per day, then you should be profitable. If production consistently fails to meet that standard, then you’ll need to figure out where the problem is.

A Fair Way To Cover Costs

If you’re paying an hourly wage, you can continue to do so, up to whatever base rate you had included in your production unit cost. If you’ve been paying straight commission, then you would continue to offer performance-based pay, but instead of it being a percentage of the sale (or a percentage of sold labor), you would pay a fixed amount per sold production unit. For example, if you budgeted for $75,000 per year for typical commissions, and used 1,000 production units as your standard, then you could pay up to $75 per production unit sold and never have to worry about labor costs.

In either case, if your overhead budget grows, you can increase your budgeted cost per production unit as needed without having to increase the rate of compensation. This helps to keep your selling prices in line without having to play shell games with your technician pay.

A Fair Way To Pay Bonuses

High performers - those who exceed production targets - are certainly worthy of bonuses. The good news is that if a service professional produces more production units than budgeted, the company can reward the added production out of the surplus production revenue.

Here’s how it works: If you based your production budget on 1,000 units, then all of your overhead and base wages have been covered at the point when 1,000 units have been sold and delivered, regardless of the total sales. Surplus production, over and above the budget, will incur very little overhead expense since budgeted overhead was covered by the first 1,000 production units. This means a greater portion of the production unit selling price can be used to pay bonuses.

There are different ways to divvy up the bonuses but here’s an example: Let’s say you had settled on a base pay rate of $75 per sold production unit. A company in this pay range would probably be selling each production unit for $300 or more so if you wished, you could pay out the bonus production units at double ($150 per unit instead of $75) and still be profitable.

A scenario for a company paying by the hour might work like this: If the service professional is earning $30 per hour and delivers bonus production, then the company could increase that professional’s base hourly rate by a fixed amount per hour per surplus unit delivered. (This can help you pay a bonus to an hourly worker and still comply with the FSLA bureaucracy.) Either way, the service professional earns a significant bonus which is paid out of surplus revenue.

Support Staff Benefits, Too!

In case you haven’t figured it out yet, a production-focused compensation plan begins with employee compensation first. Set up the program in order to take care of service professionals, support staff and management first, then fill in the numbers accordingly.

With a bit of forethought, your overhead can include bonus funds for your support staff. You could set up a program where each staffer gets an extra boost in his or her hourly rate whenever your production team achieves or exceeds its production target. This incentive helps to promote teamwork as well as peer-to-peer motivation. Your service manager should get in on the production bonus game as well. If you figure it into your budget, you can pay a bonus based upon the number of service professionals meeting the production goal. The more that hit the goal, the better the bonus will be.

Materials Sales = Gravy

You’ve probably been wondering why I haven’t included product sales as part of the equation. In the PHC service arena, production is king. Sold production is what covers the cost of running the business. That’s not to ignore the value of product and materials sales, which can certainly provide a big sales-and-profits boost. Since your overhead, including labor, is covered in the production unit cost, your materials costs can use the same net margin as your labor/overhead margin.

Since your primary goal is to deliver production, consider paying materials commissions or bonuses only after your service professionals have achieved production bonus status. Include enough margin in your selling price so that you can offer sales bonuses based upon the total selling price, rather than separating materials. This provides a greater bonus incentive for both sales and production, while providing a simple method for your sales professionals to keep track of earnings.

The Main Thing

Your service professionals will need to keep up with two numbers. First and foremost is their sold production units. The world doesn’t begin to rotate until they’ve achieved their base production goal. Once that happens, the next number that matters is their total sales, where they can earn additional bonuses.

As long as your company is meeting its production unit goal, it’s making money, regardless of what the gross sales dollars look like.