We hope that all contractors and home & garden retailers understand that you have to markup your costs to cover your overhead costs of doing business and to generate a Net Profit return on the dollars and time you have invested in your business but not all business people understand how to develop and apply markup correctly and end up ‘leaving money on the table’ or even worse paying to do the project.
Understanding The Different Types of Markup
In the contracting world there are basically two types of markup methodology that contractors will use: a Total Volume Based Markup Method that places a markup to achieve a prescribed Gross Profit on the sum of all the Labor, Materials, SubContractor, and Equipment costs.and a Capacity Based Markup that places the responsibility of recovering overhead costs on the available production capacity (or labor) a company has.
We make no bones about it, we teach and work with contractors and other service businesses to help them implement and understand the more robust Capacity Based Markup methodology because of the dangerous flaws in the Total Volume Based Markup Method . See a couple of our blog articles for more on why we feel the way we do:
- Comparing Markup Methodologies In Real Some World Pricing Scenarios (Nov 21, 2008, revised April 10, 2014)
- One of the Potential Problems in Using a Traditional Volume Based Markup May 17, 2004, , revised April 10, 2014)
- Pricing Spec Homes Using a Capacity Based Markup Model Dec 14, 2005, revised April 10, 2014)
- What Can We Learn From This Chart? (Jan 30, 2009, revision coming , revised mind April 2014)
In the first chapter of his excellent book Pricing for Profitability: Activity-Based Pricing for Competitive Advantage 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 may 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.
Some of our book recomendations of Markup, Pricing, and Activity Based Costing:
By David Gerstel
List Price: $24.95
Amazon Price: $16.47
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.
By Ellen Rohr
List Price: $19.99
Amazon Price: $14.99
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.
By Matt Stevens
List Price: $29.95
Amazon Price: $19.77
By Robert S. Kaplan & Steven R. Anderson
List Price: $45.00
Amazon Price: $29.70
By John L. Daly
List Price: $105.00