Over the course of the last year and a half, I’ve grown increasingly perturbed reading a lot of the talk surrounding Markup and Profit in the Journal of Light Construction forum of that same name. Recently there was a question posted there by a fellow asking:
I own a small kitchen and bath remodeling company Northeast of Boston and recently got my construction supervisors license. My customers seem to like my work because they keep asking me to do more and more things. As a result, my business is expanding into new areas that don’t relate directly to kitchens and baths. This has caused us to sell more work that involves the use of subs. I am looking for some guidelines for marking up subcontractors bids.
The subs I typically use are electricians, plumbers, painters, and plasterers. We handle the carpentry ourselves.
Also, in addition to mark-up, do I figure in these subs when I calculate my contingency add ons?
Any feed-back would be welcomed.
To which the forum moderator Michael Stone author of Markup and Profit — A Contractor’s Guide replied:
If you want to make more than a living in this business, then your markup should remain the same across the board. Add up all your job costs, which include labor, materials, subs and other costs and then apply a uniform markup to the lump sum of the estimate. Doing the type of work that you do, you should be using a minimum markup of 1.55 to 1.60, risk and all else considered.
Trying to use a variable markup, ie…one for labor, another for materials, still another for subs is a waste of time. If people who do that would spend as much time polishing up their sales skills as they do try to figure out ways to cut their own prices, they would probably sell twice the volume they do and make the minimum 8% net profit that is needed in this business.
I guess after 40 + years in this business and the last 25+ studying the reasons contractors go broke, I have to wonder why people keep trying to make this business more complicated than it needs to be.
Since this forum opened early last year, I have not seen one new or different approach to business than I have seen at least a half-dozen times over that same 25 + years.
KIS. Cut your markup on anything you can afford to pay for out of your own pocket.
No offense intended to Mr Stone but using his “simple” method (although I first learned it from Walt Stoeppelwerth another remodeling industry guru) of just “adding up all your job costs, which include labor, materials, subs and other costs and then apply a uniform markup to the lump sum of the estimate” wiped me out a 18 years ago when I first went out on my own. In his forums whenever the discussion of alternative (or in my estimation better more specific and relevant) markup methods were brought up rather than making any effort to examine the math in the scenarios where his method fails he would just recite his KIS mantra. Keep It Simple.
Well sometimes just Keeping It Simple can be anywhere from dangerous to fatal to a business. Sorry, Mr. Stone but building and remodeling are really extremely complex entities and a simple absolute rule ignores that complexity such as that is wrong. I think it’s time that the idea of a blanket applied markup being added to a bucket full of various job costs get added the list of sacred cows we need to slaughter.
I’ve even got to wonder in his book in the chapter Understanding Markup when Mr Stone defines Overhead he says:
Overhead is all indirect job-related expenses. Put another way, it’s any expense, fixed or variable, that you can’t charge directly to a particular job, but will spread out over all the jobs you do. That would include office rent or mortgage payments, office staff, a computer or related equipment, office phones, insurance, payroll taxes, a bookkeeper, and so on.
Of course you’ll have to separate fixed and variable overhead, but that’s not important to this discussion. To calculate the right selling price for your work, you need to use your total overhead cost not any particular piece of it.
Separating and understanding “fixed and variable overhead,” aren’t important to the discussion? How can that possibly be? Especially when you’re talking about “variable overhead”. If the overhead is variable how can the drivers of that variation possibly be ignored when calculating markup? I just think (and I know from my own experience) that that is just crazy.
Einstein once said “Everything should be made as simple as possible, but not simpler.”
While in many cases I understand Mr Stones advocacy is part of his supporting his methodology when it get compared to the PROOF system (the trade name for that PROOF Management Consultants give to their explanation of what is known in other industries as Distributed or Indexed Markup) but since the Blanket Markup method only works consistently for a companies with a certain consistent and constant mix or ratio of labor to materials to sub-contractors it’s time to both explore and advocate a better system and that what I hope to do here.
Just today I was re-reading the book Cooperate to Compete: Building Agile Business Relationships and in Chapter 19 Follow The Money there was a section called “Why The Traditional Costing Method Is Wrong”. in that section the authors quote an another author who a hundred years ago wrote
it is very usual practice to average this large class of [overhead] expense and to express its incidence by a simple percentage either upon wages or upon time…As a guide to actual profitableness of particular classes of work it is valueless and even dangerous … in the case of a machine shop with machines all of a size and kind, performing practically identical operations by means of a fairly average wage rate, it is not alarmingly incorrect. If however, we apply this method to a shop in which large and small machines, highly paid and cheap labor, heavy castings and small parts, are all in operation together, then the result, unless measures are taken to supplement it, is no longer trustworthy”
And then a few paragraphs later they write and again quote another author:
Holden Evans, a naval contractor around the turn of the century, described how even then cost accounting practices were driving businesses to difficulties:
”In some of the large establishments with numerous shops the expense burden is averaged and applied on the basis of direct labor–notwithstanding the fact that in one the expense percentage is nearly a hundred while in another it is less than twenty-five. Frequently, such establishments are called on to bid for work which is almost exclusively confined to the shops where the expense is low, and by using the higher average rate the bids are high and the work goes to other establishments where costs are more accurately determined. Thus profitable work is often lost. ”
The identical source of error persists today. Many businesses, large and small, are equally misled every day by traditional costing methods. They give up profitable products or emphasize losing ones, because of the cost formula, not because of the realities of the realities of the costs. The inventors of cost accounting methods knew that they could be applied only to similar operations in single-activity companies, yet we continue to apply them today without realizing that they are so flawed as to be dangerous.
Yeah based on both my experiences and from what I’ve read and what I am learning now about “ThroughPut Accounting” I think that the traditional Blanket Markup Method advocated by both Michael Stone and Walt Stoeppelwerth needs to be reconsidered.