Comparing the Traditional Volume Based Markup
vs.
a Capacity Based Markup Methodology
(aka a PROOF/Indexed/Labor Allocated Markup Method)

(Originally posted in February of 2004) I recently got up one morning and checking the Journal of Light Construction homepage I spotted something under the “New This Month” section that said “Business-Allocating overhead to labor” and clicked on it and was happy to find an article Allocating Overhead to Labor Makes Financial Sense by Irv Chasen’s the founder of PROOF Management consultants. Personally I took a seminar course back in 1987 called “How to Survive & Prosper in the Contracting Market” where Mr Chasen taught his method of markup which allocates overhead recovery to labor and it completely changed and rescued me from the way I was doing business beforehand.

One of things I always liked about Mr Chasen presentation of his methodology back in 87 that he makes infers again in his article is that applying markup isn’t about just arbitrarily applying a number, it’s about approaching the recovery of overhead SCIENTIFICALLY! It’s not about using a number like the “magic 1.67” we always seem to hear it’s about a SCIENTIFIC METHOD for determining what the correct number is and how that number to the correct index.

The paragraph I think that is key to beginning to understanding the strength in a Labor Allocated Overhead methodology and related to my own experience is where he writes: “Builders often allocate overhead by adding a percentage to labor and material combined. This may work well for some companies, particularly when the labor-to-material mix remains about the same on most of their jobs. However, more often than not, this will not hold true. Typically, relating overhead to labor and material combined can produce mixed results, while recovering overhead as a percentage of labor alone is far more accurate.”

Since I was already working on developing examples of the potential problem using a traditional volume based markup can cause as part of something else I’ve been working on I thought I’d publish a few examples and explore to two methods further. The scenario I’ve created to explain the potential problem while hypothetical is based on what happened to me in my own real life situation when I first started on on my own in the contracting business back in 1985-87 so take heed it can really happen in real life and the symptoms and effects of the problem are probably diagnosed and attributed to other factors more often than not.

Part 1- The Potential Problem Using a Traditional Volume Based Markup

CClick to download the Excel Spreadsheet that was used to model the scenarios in this paper. (Windows & Macintosh)

Lets say my buddy an I have been working for several years for this one company and one day our boss tells that he’s planning on closing up shop and retiring within the next year so he tells this so we can make plans. We decide we’ve really enjoyed working together so we decide to start our own company when our boss finally closes down and we use our time left to create a pro forma plan of what we are going to do and what we are going to charge for it.

We’re going to pay ourselves $25 per hour which works out to $1000 per week or $52,000 per year. With burden it comes to a cost of $30.50 per hour ($1173.11 per week per person and $2346.23 for two people) or approximately $10,167 per month in labor costs for the two of us.

We want to keep on doing what we’ve been doing for years so we decide the projects we are going to do are are nice custom architectural woodworking installations. All hardwood molding and cabinets. Cherry, mahogany and a little bit of oak. Based on the finish carpentry projects we’ve done in the past with our old boss we’ve figured out that for every dollar spent on the Cost of Production Labor there is approximately $1.56 spent on materials. That means for the $10,167 of Production Labor Cost each month we should expect to see a $15,860 of Material Costs

Next we set out to figure out what our Overhead Costs are going to be,

While we have some work lined up to get us started to generate new leads we’ve given ourselves a monthly budget of $600 ($7200 per year) to advertise in the local news publications and home and garden magazines.

We plan to compensate ourselves for our estimating and sales efforts with $900 dollars each per month for a monthly budget of $1800 ($21,600 per year).

We going to hire a daughter who’s a recent college graduate for $1600 a month to answer phones and take care of the books. We’ll rent a small space in an industrial complex where we have about 750 SF of space to park a truck or use as small shop and 150 SF to run our office out of for $825 per month ($12,000 per year). We have budgeted $900 per year for our Office Equipment, $600 per year for our Telephone service, $3240 for our Computer Expenses, and $70 per month ($840 per year) for our Office Supplies.

We’ve have a budget of $900 per month to cover the payments, maintenance, and fuel for our two vehicles. Since my partner and I are going to be doing all the work ourselves we have not created a budget figure for Job Supervision. We have created a month budget of $550 ($6600 per year) to maintain our existing tools and purchase any new ones. We have a yearly Service & Callback budget of $1200 to handle any problems that might come up. We figure $140 per month to cover our Mobile Telephone service and nothing for Pagers since our Mobile Telephone service has that service built into their plan.

We plan to compensate ourselves each $900 per month as an Owners Salary for the general administrative chores we will have to do in addition to the on the job labor we’ll be performing. Our General Insurance will run $9600 per year. We plan to sock away $1200 per month to build up an Operating Cash Reserve Account (O.C.R.A.). We have planned a budget of $245 per month for Interest. We have a planned budget for $600 per year for our local county and town taxes. We have a budget of $900 per year to cover for any Bad Debt. $900 for all our Licenses & Fees. We’ve set up yearly budget figures of $2160 and $2040 respectively for Accounting and Legal fees. We’ll budget $12,000 per year for Education & Training, $275 for Entertainment, and $1800 per year for Association Fees.

Plugging them all into a spreadsheet we get something that looks like this:

Overhead Costs
Overhead Item Per Month Per Year
Advertising 600 7200
Sales 1800 21600
Office Expenses
Staff 1600 21600
Rent 825 12000
Office Equipment 75 900
Telephone 50 600
Computer Expenses 270 3240
Office Supplies 70 840
Job Expenses
Vehicles 900 10800
Job Supervision 0 0
Tools & Equipment 550 6600
Service & Callbacks 100 1200
Mobile Telephone 140 1680
Pagers 0 0
General Expenses
Owners Salary 1800 21600
General Insurance 800 9600
O.C.R.A 1200 14400
Interest 245 2940
Taxes 50 600
Bad Debts 75 900
Licenses & Fees 75 900
Accounting Fees 180 2160
Legal Fees<span
style=”mso-spacerun: yes”>
170 2040
Education & Training 1000 12000
Entertainment 275 3300
Association Fees 150 1800
TOTALS $13,000 $156,000

We plug all those numbers (Monthly Labor Costs, Monthly Material Costs, and Overhead) into a table and we decide well add $4400 per month for profit (which works out to be equivalent to 10% of Sales) so at a that should net us $52,800 in profit at the end of the year that we can split between us or reinvest in one way or another.

Our Pro Forma Financial Projections
Labor Costs Material Costs Total Direct Job Costs Overhead Total Costs Sales Profit
Typical Per Month 10,167 15,860 26,027 13,000 39,027 43,427 4,400
as % of Sales 23.4% 36.5% 59.9% 29.9% 89.9% 100.0% 10.1%

We extend those numbers out over the year and we get a spreadsheet that shows us our anticipated results below

Our Pro Forma Financial Projections
Year 1
Labor Costs Material Costs Total Direct Job Costs Overhead Total Costs Sales Profit
January 10,167 15,860 26,027 13,000 39,027 43,427 4,400
February 10,167 15,860 26,027 13,000 39,027 43,427 4,400
March 10,167 15,860 26,027 13,000 39,027 43,427 4,400
April 10,167 15,860 26,027 13,000 39,027 43,427 4,400
May 10,167 15,860 26,027 13,000 39,027 43,427 4,400
June 10,167 15,860 26,027 13,000 39,027 43,427 4,400
July 10,167 15,860 26,027 13,000 39,027 43,427 4,400
August 10,167 15,860 26,027 13,000 39,027 43,427 4,400
September 10,167 15,860 26,027 13,000 39,027 43,427 4,400
October 10,167 15,860 26,027 13,000 39,027 43,427 4,400
November 10,167 15,860 26,027 13,000 39,027 43,427 4,400
December 10,167 15,860 26,027 13,000 39,027 43,427 4,400
Yearly Total 122,004 190,320 312,324 156,000 468,324 521,124 52,800
as % of Sales 23.4% 36.5% 59.9% 29.9% 89.9% 100.0% 10.1%

Looking at that pro forma plan we can take $522,820 in pro forma Sales and divided it by the $312,320 in anticipated direct job costs and we get a figure of 1.67 that we can use. If we take our estimated Direct Job Costs for any one particular project on it own and multiply it by 1.67 will get the desired Sales price that will cover our Overhead and earn the Profit we want. In fact that 1.67 markup is the same markup that we see so many trade industry consultants recommend we use to achieve a desired %40 Gross Profit margin.

Total Direct Job Costs Markup Sales
$312,324 1.67 $521,124
Total Direct Job Costs Gross Profit
(OH + Profit)
Sales
$312,324 $208,800 $521,124
%59.9 %40.1 %100

So we start off on our first year in business for ourselves. The first two months, the first two projects come off without a hitch and are true to our pro forma predictions. The next two months of projects are just like the first two except instead of cherry, mahogany and oak our clients decide they want painted woodwork and cabinets so instead of billing for $15,860 of materials we’re only billing for $11,102.

Starting that May we get a gig working for a GC that will have us doing the finish work for 8 houses for him and that should carry us through the rest of the year without us having to look for anymore work until we’re done with them only the GC and the architect, since they will be personally working with the home buyers on their product selections, will supply all the major materials such as interior doors and cabinets. We only have to supply the base, crown, casing, and general moldings and the fasteners we want to use such as nail and screws.

Our first thought it great! we no longer have to deal with the hassle of getting those materials. There no crimp on our cash having to extend money our of our pockets for materials until we get paid for them but another problem soon becomes evident. That reduces our Material Costs to 40% of what we would have gotten had we been providing all the materials.Not having those Material Costs to “markup” on we no longer have those markup dollar contributing to our Overhead expense which has remained a constant $13,000 per month.

Actual Year 1 Labor Costs Material Costs Total Direct Job Costsb Costs Overhead Total
Costs
Sales Profit
January 10,167 15,860 26,027 13,000 39,027 43,427 4,400
February 10,167 15,860 26,027 13,000 39,027 43,427 4,400
March 10,167 11,102 21,269 13,000 34,269 35,488 1,219
April 10,167 11,102 21,269 13,000 34,269 35,488 1,219
May 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
June 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
July 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
August 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
September 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
October 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
November 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
December 10,167 6,344 16,511 13,000 29,511 27,549 (1,962)
Yearly Total 122,004 104,676 226,680 156,000 382,680 378,224 (4,456)
as % of Sales 32.3% 27.7% 59.9% 41.2% 101.2% 100.0% -1.2%

In the end our Net Profit figure shows a loss! The result falls $57,256 short of our expectations ($52,800 pro forma profit + the $4,456 loss). Instead of taking part of that $52,800 and splitting it with my partner to supplement the wages we paid ourselves we now have to did into the paychecks we paid to ourselves to pay out of pocket for our operational loss.

Part 2-The Solution Dealing With the Problem using a PROOF/Indexed/Labor Allocated Overhead methodology.

Dealing with the same numbers as the we used in the previous example my buddy and I are going to use a PROOF/Indexed/Labor Allocated Overhead methodology as Irv Chassen talks about in Journal of Light Construction Article Allocating Overhead to Labor Makes Financial Sense, instead of the Traditional Volume Based Markup. (Mr Chassen was the founder of PROOF Management Consultants hence the reason why the method is often referred to just as PROOF in the building and remodeling community)

We again have all the same baseline projections as we did in our initial pro forma planning.

Our Pro Forma Financial Projections
Labor Costs Material Costs Total Direct Job Costs Overhead Total Costs Sales Profit
Typical Per Month 10,167 15,860 26,027 13,000 39,027 43,427 4,400
as % of Sales 23.4% 36.5% 59.9% 29.9% 89.9% 100.0% 10.1%

Looking at the same set of projection numbers again instead of taking the sum of Labor Costs and Material Costs and then multiplying that number by a markup figure to achieve our desired selling Price we going to come up with a different markup multiplier that will work off of just our Labor Cost (since our Labor Cost for all intents and purposes stays the same or stays within the range of what’s called Common Cause Variation) month to month.

For a second lets ignore the Material Costs figure all together. We are still going to work just as hard, the same amount of hours and we’ll still want to pay ourselves the same so the labor costs remain $10,167. We also still want to make the same $4,400 per month in Net Profit and our Overhead is still going to be the same $13,000. Looking at it from a different perspective now our Labor Cost can be seen as representing %53.1 of sales and that same desired Net Profit of $5000 per month now represents %23.4 of Sales.

Our Pro Forma Financial Projections Ignoring Material
Labor Costs Total Direct Job Costs (no materials) Overhead Total
Costs
Sales Profit
Typical Month

10,167

10,167 13,000 23,167 27,567 4400
as % of Sales
(with Labor only, no Material Costs)
%36.9 %36.9 %47.2 %84.0 %100 %16.0

If I take the new Sales figure of $27,567 and divide it by the $10,167 Labor Cost we come up with a new markup figure to use of of 2.71. If I multiply any estimated Labor Cost figure by 2.71 it will return me a number that then covers our Overhead and earns us our desired Profit proportional to the estimated Labor Cost.

We can now extend out our pro forma predictions for the coming year like this:

Our Extended Pro Forma using a PROOF/Indexed/Labor Allocated Overhead methodology.
Year 1 Labor Costs Total Direct Job Costs Overhead Total
Costs
Sales Profit Material Costs Total Volume
January

10,167

10,167

13,000 23,167 27,567 4,400 + 15,860 = 43,427
February 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
March 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
April 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
May 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
June 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
July

10,167

10,167

13,000 23,167 27,567 4,400 15,860 43,427
August 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
September 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
October 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
November 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
December 10,167 10,167 13,000 23,167 27,567 4,400 15,860 43,427
Totals 122,004 122,004 156,000 278,004 330,804 52,800 190,320 521,124

In this same table now using a different markup system we’ve still achieved the same total volume figure as we did using the Traditional Volume Based Markup. And perhaps even more importantly we separated achieving our Overhead and Profit figures from any dependency on selling a particular volume of materials. If we don’t sell any Materials at all we will still completely cover our overhead and earn our desired profit!

However in his JLC article Mr. Chassen when giving his example of company using the PROOF methodology mentions

” Remember as you read this that we are discussing only overhead recovery, and that all costs — labor, materials, and overhead — should also be marked up for profit.” (my emphases)

In the example above we already marked up our Labor and Overhead for profit while ignoring materials and selling them at their literal cost. We could however then apply a discrete and separate Markup on the Materials segment of the project This is also more in line with the thinking behind Activity Based Costing methodologies. Activity Based Costing is form of cost accounting that focuses on the costs of performing specific functions (processes, activities, tasks, etc.) rather than on the aggregated costs of the organizational unit or company. ABC generates more accurate cost and performance information since it related more specifically a particular costs associated with a specific product or service.

In other words a markup figure that would be applied independently to any Materials Costs would reflect the costs associated with procuring the materials. If you could arrange to have all your materials delivered by you supplying lumber company you could perhaps just use a markup of %6 for a Net Profit. In my companies we haven’t been able to do that since we often have to go to our hardwood supplier and pick out our wood based on grain patterns and appearance but after studying how much time we spent selecting our own material we found it came to %9 of the Cost we paid for materials so we apply a 15% markup on any Materials we supply for a project (%6 + %8 = 15%).

Now using this method if we do sell Materials we earn an additional Net Profit on those materials while also covering our typical costs associated with procuring the material! (note-In the cases where the costs associated with acquiring materials stray out of the realm of “typical” an into extraordinary such as they need to be shipped FedEx from Sweden we plan for and bill for those charges as Direct job Costs).

Part 3 – Summing things up.

What makes the PROOF/Indexed/Labor Allocated Overhead methodology a better choice as a markup strategy over the traditional volume based markup method so many of us first learned is that it isolates and protects a company’s recovery of Overhead Costs and ability to generate a Profit from the fluctuations and variations in the amount of Material and Subcontractor Costs in a project and instead ties Overhead recovery and Profit generation to the much more reliably predictable Internal Labor component (which while expressed here as Labor Cost it can also be expressed as Time).

Interestingly I recently found in the automobile service industry the methodology isn’t called PROOF, it’s referred to “indexed” markup. I’ll infer that that’s because the rate for overhead recovery is based on or “indexed” to the the billable hours that a mechanical shop can perform in a year.

From what I’ve gathered through some consulting I’ve done with an small aerospace defense job shop contractor 99% of the companies involved in that industry also practice the same methodology although its not given any special names there, it’s just the way it’s done. Why? Because of essentially the same problem I mentioned above with regard to materials. When an aerospace contractor works on a government contract all of the materials are supplied by the government so they can’t mark it up for overhead and/or profit. Those aren’t small businesses at all and they are a lot more complicated and sophisticated than we in the building and remodeling industry so the “doesn’t work for larger contractors” argument fails on that count.

Part 4 – Getting You Own Company Setup with a PILAO (Capacity Based) Type Markup

We’ve developed a 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 Capacity Based Markup Worksheet  page on our 360Difference.com software site.

Part 5 – Other articles discussing the use or application of a PROOF/Indexed/Labor Allocated Overhead methodology.

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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J. Jerrald Hayes
Primus Inter Pares at Paradigm Projects, Ltd.
I am an architectural woodworker and general contractor turned IT, Business and Project Management consultant, software developer wannabe senior division triathlete and ski racer, Yankee fan and founder of ParadigmProjects.com, 360 Difference Mac4Construction.com,iOS4Construction.com and now TheBuildingAndRemodelingWiki.com too.

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