Comparing Markup Methodologies In Real Some World Pricing Scenarios

Introduction

Through out the web you’ll find blurbs for one of the best selling books on understanding markup for contractors saying (the emphasis is mine):

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.

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 .

Part 1 – Labor Costs

Both contractors set about figuring the real Actual Cost for their Labor.

Without considering their compensation for owning and running a business, performing office work estimating and the like they decide that they want to pay themselves a wage of $24.00 per hour (plus some benefits like health insurance and retirement) for their time out in the field which they anticipate will be spent doing the actual work themselves but that wage will also compensate them for the time they spend supervising any subs they have hired for any particular project too. They are the owners of their own businesses and the only employees which means they are exempt from the obligation having to cover themselves with Workers Compensation however they decide to do so anyway so that they are then insured if they get hurt on the job. They plug in the costs for all those items and what they get for their estimated yearly Labor Cost appears in the chart below.

Labor Cost
Labor Cost Item
$ Per Year
Base Hourly Wage
2040 hrs @ $24.00 per hr.
$48,960.00
Basic Common Burden Costs
Workers Compensation
$8255.00
FICA & Medicare

$3745.00
State Unemployment Tax

$162.00
Federal Unemployment Tax

$56.00
Benefits

Health Insurance

$4500.00
Dental Insurance

$420.00
Retirement

$490.00
TOTAL YEARLY LABOR COST
$66,587.70

Contractor B, Bill is done with his Labor Cost figuring for the time being but Contractor A, Aaron, goes on to look at how the hours he is going to pay himself for actually break down. While he is going to actually “work” for 51 weeks in the year, 8 hours a day, 5 days a week for a total of 2040 hours he knows not all of that time is going to be productive work he can charge to his client’s project budgets. He is going to give himself 5 paid holidays and a week (5 days) of paid vacation. He also plans to compensate himself for some 16 hours of training he wants to take and he figures a budget of 52 hours (about an hour per week) for downtime where he is just chatting with clients or subs or fixing tools and can’t in his mind charge that time to his client’s project budgets. That figuring works out to 148 hours of Non-Billable time so he subtracts that from the 2040 Total Hours and comes up with an estimate of 1892 Billable Hours that he will work.

He then takes that figure he worked out earlier for his Total Yearly Labor Cost of $66,587.70 and divides that by the 1892 Billable Hours to come up with a True Hourly COST for the hours he can charge to his client’s project budgets and that works out to a labor Cost of $35.19 per hour.

Billable Hours vs Non Billable Hours Worksheet
Labor Hours Item
$ Per Year
Anticipated Total Work Hours

2040

Anticipated Non-Billable Work Hours

148
Anticipated Billable Work Hours

1892
LABOR COST PER ACTUAL HOUR WORKED (2040)
$32.64
LABOR COST PER BILLABLE HOUR (1892)
$35.19

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.

Fixed Overhead Costs
Overhead Item
$ Per Year
General Office Operation & Expenses
18,254.10
Capital Equipment
7520.00
Marketing
5370.00
General Insurance
2600.00
Professional Fees
700.00
Local & Regional Business Taxes
100.00
Contingency & Reserves
8000.00
Owners Compensation (Draw)
5000.00
Sales Compensation
6000.00
Total Overhead Costs

$54,544.10

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).

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.

Aaron’s, Contractor A’s, Loaded Labor Rate Computation
Total Yearly Labor Costs
$66,587.70
Total Yearly Overhead Costs

$53,544.10

Net Profit

$13,367.00

Total Labor Sales

$133,498.80

Billable Hours
1892
AARON’S LOADED LABOR RATE

$70.56

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).

Owner’s Compensation
Owners Wages for Field Work
$48,960.00
Owners Compensation for Office Work

$6,000.00

Owners Compensation for Estimating Work

$7,500.00

Owners Compensation for Sales Work

$6,000.00

Owners Draw

$5,000.00

TOTAL COMPENSATION

$73,460.00

plus: NET PROFIT

$13,367.00

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:

Total Job Costs
Labor
$66,587.70
Materials

$54,752.20

SubContracting

$34,660.80

TOTAL JOB COSTS

$156,000.70

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.

Bill’s, Contractor B’s, Sales Summary
Labor
$66,587.70
Materials

$50,752.20

SubContracting

$34,660.80


TOTAL JOB COSTS

$152,000.70
OVERHEAD

$54,544.10

NET PROFIT

$22,609.93

TOTAL SALES VOLUME

$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.

Bill’s Owner’s Compensation & Net Profit
Owners Wages for Field Work
$48,960.00
Owners Compensation for Office Work

$6,000.00

Owners Compensation for Estimating Work

$7,500.00

Owners Compensation for Sales Work

$6,000.00

Owners Draw
$5,000.00
TOTAL COMPENSATION

$73,460.00
plus: NET PROFIT
$22,609.93

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.

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. A Project with Labor, Materials, and SubContracting in the Same Ratio That Used in the Markup Planning Process with a

Job #1 – A Project with Labor, Materials, and SubContracting in the Same Ratio That Used in the Markup Planning Process.

Both contractors go out into business and for the first project they look at a job that fits right into the mold of the typical job they are looking for.

Aaron, Contractor A:

Aaron, Contractor A looks at the project and and figures it will take 140 hours of his effort with Material Costs of $8207.77 and SubContracting Costs of $5,195.92 so he takes those figures and plugs them into his formula:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x 1.1) + (SubContractor Costs x 1.1) = Selling Price
(140 hrs. x $70.56) + ( $8207.77 Matl Costs x 1.1) + ($5,195.92 SubContract Costs x 1.1) = Selling Price

$24,756.44 = Aaron’s Selling Price

Aaron, Contractor A
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$70.56
$9,878.35
Labor
$9,878.35
Materials Cost
$8,207.77
1.11
Materials
$9,110.62
Sub Contracting Cost
$5,195.92
1.11
SubContract
$5,767.47
Total
$24,756.44

vs.

Bill Contractor B:

Bill Contractor B, then takes his formula and plugs in his figures. He figures 140 hrs at a Labor Cost of $32.64 (instead of a Loaded Billing Rate). He then takes that resulting figure of $4569.74 for his Labor Cost and adds to it his Material and SubContracting Costs (which are the same as Aaron’s) of $8207.77 and $5,195.92 respectively and then multiplies that sum of $17,973.43 by his 1.5 Markup to get a Selling Price of $26,960.15.

(Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price
($4569.74 Labor Cost + $8207.77 Matl Costs + $5,195.92 SubContract Costs) x 1.5 markup = Selling Price
$17,973.43 x 1.5 markup = Selling Price

$26,960.15 = Bill’s Selling Price

Bill, Contractor B
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$32.64
$4,569.74
1.5
Labor
$6,854.62
Materials Cost
$8,207.77
1.5
Materials
$12,311.66
Sub Contracting Cost
$5,195.92
1.5
SubContract
$7,793.88
Total Costs
$17,973.43
1.5
Total
$26,960.15

Comparison:

Well there is no real problem or discrepancy between the two methods in this case. While Bill’s Price for the project is about 9% more than Aaron’s they are really are both in the same competitive ballpark when looking at this project. The one problem possibly exists for Bill is that with this Job the ratio of Labor Cost to other Job Costs is what Bill has designed his Overhead recovery around. To cover his Overhead and earn a Net Profit for the time this job takes Bill has to get this job or jobs like these or ones with higher Material and SubContracting Costs or he will not be making his target numbers.

The Capacity Based Markup strategy that Aaron has used gives him a slightly better price position on this particular project and all other things being equal if the client then makes a decision on price Aaron gets this job.

For what it’s worth though if Bill had set up his markup strategy based on slightly lower estimated sales volumes of labor and materials his price for the project would have been the same as Aaron’s.


Job #2 A Project with Low Relative Cost of Labor to High Cost of Materials, and SubContracting

In this project scenario both contractors are looking at a project with a high cost of materials and subcontracting in relation to the labor involved. This scenario could represent a project where the client has made very high end choices as to what kinds of materials they want in their project.

Aaron, Contractor A:

Aaron, Contractor A looks at the project and and figures it will take 140 hours of his effort with Material Costs of $32,464.00 and SubContracting Costs of $12,567.00 so he takes those figures and plugs them into his formula:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x 1.1) + (SubContractor Costs x 1.1) = Selling Price
(140 hrs. x $70.56) + ( $32,464.00 Matl Costs x 1.1) + ($12,567.00 SubContract Costs x 1.1) = Selling Price

$ 59,862.76 = Aaron’s Selling Price

Aaron, Contractor A
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$70.56
$9,878.35
Labor
$9,878.35
Materials Cost
$32,464.00
1.11
Materials
$36,035.04
Sub Contracting Cost
$12,567.00
1.11
SubContract
$13,949.37
Total
$59,862.76

vs.

Bill Contractor B:

Bill Contractor B, then takes his formula and plugs in his figures. He figures 140 hrs at a Labor Cost of $32.64 (instead of a Loaded Billing Rate). He then takes that resulting figure of $4569.74 for his Labor Cost and adds to it his Material and SubContracting Costs (which are the same as Aaron’s) of $8207.77 and $5,195.92 respectively and then multiplies that sum of $17,973.43 by his 1.5 Markup to get a Selling Price of $26,960.15.

(Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price
($4569.74 Labor Cost + $32.464.00 Matl Costs + $12,567.00 SubContract Costs) x 1.5 markup = Selling Price
$49,600.74 x 1.5 markup = Selling Price

$74,401.12 = Bill’s Selling Price

Bill, Contractor B
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$32.64
$4,569.74
1.5
Labor
$6,854.62
Materials Cost
$32,464.00
1.5
Materials
$48,696.00
Sub Contracting Cost
$12,567.00
1.5
SubContract
$18,850.50
Total Costs
$49,600.74
1.5
Total
$74,401.12

Comparison:

In this scenario will Bills price for the project being 24% higher than Aaron’s Bill may have indeed priced himself out of getting this project. While with all other things being equal Aaron most likely will get this job if Bill did get this project for some reason what he does get out of is that he has more than covered his overhead costs and target profit would indeed earn a surplus Net Profit thanks to the mechanics of how his markup strategy works. But again that is based on the big IF of IF he does get this project.

For Aaron provided the job comes off as planned he’ll hit his target overhead and profit numbers right on the mark.

But one of the real competitive advantages Aaron has in a Materials intensive project situation such as this is that if the client wants to make changes to project in terms of choosing different materials clients can upgrade without being penalized or restricted by a big whopping markup being placed on materials (Bill has a markup ratio on materials of 1.5 vs Aaron’s of 1.11). So for instance if the client want to move up from lets say a $400 exterior door that’s been specified to one he has seen in a show room selling for $2000 the upgrade will cost them an additional $2,400 if Bill does the job vs. Aaron’s upgrade price of $1,760

Aaron, Contractor A
Costs Aaron’s Markup Marked Up Selling Price
$400 Exterior Door
$400
1.11
$440
$2000 Exterior Door
$2000
1.11
$2,200
Upgrade Price to Client
$1,760
Bill, Contractor B
Costs Bill’s Markup Marked Up Selling Price
$400 Exterior Door
$400
1.5
$600
$2000 Exterior Door
$2000
1.5
$3,000
$2,400


Job 3 – A Project with High Relative Cost of Labor to Low Cost of Materials, and SubContracting

In this project scenario both contractors are looking at a project with a relatively low cost of materials and subcontracting in relation to the labor involved. This scenario could very well represent a project where the client (or general contractor or architect designer) is providing the materials. For all intents and purposes it is essentially a labor only contract.

Aaron, Contractor A:

Aaron, Contractor A looks at the project and and figures it will take 140 hours of his effort with Material Costs of $245.00 for incidentals and sundry items such as nails screw and glue, and there are no SubContracting Costs involved so he takes the figures he has and plugs them into his formula:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x 1.1) + (SubContractor Costs x 1.1) = Selling Price
(140 hrs. x $70.56) + ( $245.00 Matl Costs x 1.1) + ($0.00 SubContract Costs x 1.1) = Selling Price

$ 10,150.30 = Aaron’s Selling Price

Aaron, Contractor A
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$70.56
$9,878.35
Labor
$9,878.35
Materials Cost
$245.00
1.11
Materials
$271.95
Sub Contracting Cost
$—
1.11
SubContract
$—
Total
$10,150.30

Bill Contractor B:

Bill, Contractor B, then takes his formula and plugs in his figures. He figures 140 hrs at a Labor Cost of $32.64 (instead of a Loaded Billing Rate). He then takes that resulting figure of $4569.74 for his Labor Cost and adds to it his Material and SubContracting Costs (which are the same as Aaron’s) of $245.00 and $0.00 respectively and then multiplies that sum of $4,814.74 by his 1.5 Markup to get a Selling Price of $7,222.12.

(Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price
($4569.74 Labor Cost + $245.00 Matl Costs + $0.00 SubContract Costs) x 1.5 markup = Selling Price
$4,814.74 x 1.5 markup = Selling Price

$7,222.12 = Bill’s Selling Price

Bill, Contractor B
Hours Labor Rate Costs Markup Selling Price
Labor Cost
140
$32.64
$4,569.74
1.5
Labor
$6,854.62
Materials Cost
$245.00
1.5
Materials
$367.50
Sub Contracting Cost
$—
1.5
SubContract
$—
Total Costs
$4,814.74
1.5
Total
$7,222.12

Comparison:

In this scenario Bills price for the project is 24% lower than Aaron’s and while Bill may very well win this contract on price he has horribly under priced the project and will be losing money on it. For every 140 hours of company capacity consumed Bill needs to collect $8,986.72 and he’s only generating $2407.38 with this project leaving him with a $6,574.39 shortfall. That not only wipes out his net profit margin it cuts into his other overhead costs. He is in essence paying to do this project.

Again for Aaron provided the job comes off as planned he’ll hit his target overhead and profit numbers right on the mark.


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’ll 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 the 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.


Footnotes:

Further Reading & Tools

Running a Successful Construction Company

By David Gerstel
List Price: $24.95
Price: $16.47 & eligible for FREE Super Saver Shipping on orders over $25.

In Chapter 5 Estimating and Bidding of Gerstels book and more specifically on pgs 167 through 168 Gerstel talks about using what he calls a “Capacity Based Markup” which is the same thing as what is otherwise known as a PROOF or Indexed or Labor Allocated Markup which Irv Chasen, Ellen Rohr, and I all talk and write about and why it’s a safer better bet for a new contractor with a varied mixed of projects to use.

How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love

By Ellen Rohr
List Price: $24.95
Price: $16.47 & eligible for FREE Super Saver Shipping on orders over $25.

While she never uses the phrase ‘Capacity Based Markup’ in plain simple language that anyone can understand Ellen Rohr lays out and explains the mechanics of setting a price for your work using the ‘Capacity Based Markup’ methodology.

Capacity Based Markup Worksheet

We’ve developed a Shareware 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 Shareware section of our 360Difference.com software site (The PILAO Worksheet – PILAO_Wksht v2.01.xls).

Journal of Light Construction January 2004

Allocating Overhead to Labor Makes Financial Sense

by Irv Chasen

Allocating Overhead to Labor Makes Financial Sense Irv Chasen If I were to ask ten contractors how they calculate and apply overhead (indirect expense) to their estimates or time-and-material work, I would get ten different answers. If I were to press further as to how they arrived at their numbers, most of their methods would turn out to be arbitrary or have some element of guessing. For nearly 40 years, I have been working with contracting businesses to help them improve their cost-accounting systems, and most of those I have worked with had no scientific method as to how.

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.

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5 Responses to “Comparing Markup Methodologies In Real Some World Pricing Scenarios”

  1. chris magness December 10, 2008 at 3:36 pm #

    In the current market, many of my jobs are smaller repair and remodel jobs (rot repair, etc.), jobs where a bid price could insure loss, and working on a time and material basis seems to be the fairest approach for all. I would like to charge more per hour to help cover overhead, but by charging more I’d be spending a lot of time at home. Your $70/ hour and the break down with it is very logical, but double my hourly. What’s the best way to incorporate overhead and profit into a time and material job and remain competitive. My hourly is average for this area, but overhead is killing me. There isn’t much room for overhead in my hourly rate.

    Jobs with a higher material cost are more profitable, but most of my jobs have a higher relative labor cost.

  2. Jerrald Hayes December 10, 2008 at 8:40 pm #

    Hello Chris,

    As to…

    ‘In the current market, many of my jobs are smaller repair and remodel jobs (rot repair, etc.), jobs where a bid price could insure loss, and working on a time and material basis seems to be the fairest approach for all. ‘

    I’m not so sure that is necessarily right way to think about things. I can’t understand why a bid price would necessarily guarantee a contractor a loss. That said when the time involved in producing an estimate or quote is high in relationship to the time it will take to perform the job time and materials perhaps T&M is a good option but I remain a strong advocate of fixed cost pricing in terms of the value it delivers to both the consumer and the contractor.

    ‘I would like to charge more per hour to help cover overhead, but by charging more I’d be spending a lot of time at home. Your $70/ hour and the break down with it is very logical, but double my hourly. What’s the best way to incorporate overhead and profit into a time and material job and remain competitive. My hourly is average for this area, but overhead is killing me. There isn’t’t much room for overhead in my hourly rate.’

    You can’t look at the decision to charge more to cover your overhead as something you would like to do. The numbers will speak for themselves and you have to do what you have to do. If you’re not charging enough to cover your overhead where is the money to pay your overhead costs going to come from??? This may be a hard pill to swallow and not what you want to hear but if a client rejects you solely based on your hourly rate you haven’t sold them on your "value proposition". Your problem is in sales and marketing and not in the correctness of your hourly billing rate number.

    From a sales standpoint if the rate you quote is $60 per hour and the job takes you 8 hours but takes the contractor who quotes $50 per hour 10 hours then you just saved them $20 and they probably would feel better about the project.

    Or let’s say it a case of your using a Capacity Based Markup strategy to come up with loaded billing rate and you are competing with a contractor or contractors who use the Estimated Total Volume Based method you might want to point out that while your labor rate is higher you are not gouging them on the materials. In the example I illustrated in this article Aaron has a Billing rate of $70.56 vs. Bills rate of $32.64 Aaron is only marking up materials 11% to earn a 10% on them whereas Bill is marking up materials %50 for a %30 profit on them. And if the client wants to choose higher quality and consequently higher cost materials for their project you Aaron isn’t punitively punishing them for that decision the way Bill would be with his material markup.

    ‘Jobs with a higher material cost are more profitable, but most of my jobs have a higher relative labor cost.’

    Statistically speaking the smaller the job, the higher the ratio of labor to material costs will be. That’s why it even more important for a contractor to use a well designed and calculated Loaded Labor Rate.

  3. Kane Minton January 12, 2010 at 10:39 am #

    Just wanted to say Thank You! I just started my business less than a year ago and have only been exposed to Stone’s book Mark-up and Profit. I have had many of the same questions/concerns about his system for determining a selling price and have found this article EXTREMELY helpful and benificial to the way I plan to do business. Thank you for sharing you knowledge and experience so others may prosper, I will pass along all that I have learned for the benefit our industry and professionals…

  4. Heidi Simon March 25, 2010 at 9:35 am #

    I work for a construction job cost accounting and construction estimating software company and I found this article very informative! Its always good to keep learning about the industry and the way real businesses work. Thanks!

    Heidi
    Maxwell Systems

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    […] Compare various markup formulas used in real-world scenarios to determine which method is best for y… This resource offers comprehensive discussion of the various markup methodologies, outlined using real-world pricing examples. […]

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