Markup vs. profit margin
Vito, a plumbing contractor from New York, writes, “I would like an explanation of gross profit. Why is it always better to divide rather than multiply? I thank you in advance.”
Good question, Vito. I believe you are asking about the difference between a cost markup and a profit margin. Contractors are often confused about which is the right method to use regarding their selling prices. The multiplication method is a markup of cost and is used by many contractors who don’t know about or understand the other method. The division method is the way to address profit margin and looks at the profit as part of the selling price.
The markup method
Contractors using the markup method multiply the cost of a job by their desired profit percentage then add the product of this calculation to the estimated cost. If the cost to the contractor to do the job is $1,000 and the contractor wants a 10% profit, he/she would multiply the $1,000 by 10% and add $100 to his/her estimated cost to arrive at a selling price of $1,100. As long as the cost remained constant, the contractor would earn $100 in profit for the job.
There are two problems with the markup method: The contractor shortchanges him/herself and the profit margin is not 10%. Let’s prove it. A contractor who wanted to bring in some money while covering his/her cost, might offer the customer a 10% discount since he/she was under the impression that a 10% profit was being made. But, 10% of $1,100 is $110. That would leave a balance of only $990 to cover a cost to the contractor of $1,000 for the job. That proves that a true 10% profit was not attained.
Using a profit margin
The division (profit margin) method shows a true 10% and how the contractor shortchanges him/herself using the markup method. To utilize the division method, do the following:
1. Subtract your desired profit percentage from 100% to arrive at your profit margin divisor. Using the same example, 100% less 10% would give you a profit margin divisor of 90%. Similarly, if you wanted a 25% profit you would divide by 75%. You get the picture. You choose the desired profit margin and subtract it from 100%.
2. Divide your cost by the margin divisor to arrive at your selling price. In the aforementioned example job you would divide the $1000 cost to contractor by 90% to arrive at a selling price of $1,111.11 for the consumer.
This proves that the contractor shortchanged him/herself by $11.11 using the multiplication method. To further prove that the division method is better, let’s see what happens when 10% of the $1,111.11 selling price is subtracted from the selling price. What do you know? 10% is $111.11, which, when subtracted from the $1111.11 selling price leaves the contractor with the $1000 cost figure. No hits! No runs! No errors! The contractor can recover his/her cost.
Using the division method takes care of the two aforementioned problems. In the example, it gives the contractor more money ($11.11 more) at the full price and he/she truly made a 10% profit.
Be aware of the domino effect
Now that I have cleared that up, you must consider the domino effect of this knowledge. It should be noted that, regardless of which method you use, your results will suffer if you do not know your true cost and/or choose a wrong profit margin. Whenever dealing with information, and especially when computers are involved, the letters GIGO (Garbage in Garbage Out) hold the truth. If you incorrectly calculate your true cost of operation, your conclusions will be flawed. And if you choose the wrong profit margin, more garbage will pile up.
A $100 labor/overhead cost per technician/truck hour (based on selling all available annual technician hours [1,708 hours]) rises to a cost of $142.86 when you only sell 70% of your available hours. That means you would need a 30% profit margin just to break even. Let’s prove it. $100 divided by 70% (the difference between 100% and 30%) would give you a selling price of $142.86.
The amount of hours you get to sell is forever fluctuating. Keep the following points in mind when considering your profit margin and selling price.
• No contractor sells all their available annual technician hours for all their technicians all the time.
• There are periods of time when contractors are extremely busy, during which they sell all the time during those periods, and possibly more.
• During normal times, contractors probably sell at best about 70% of all their available annual technician hours.
• During recessions fewer hours are sold
• Regardless of the amount of hours you sell, the bills you accrue for the costs of operation will still come due.
• When bills are due and all time hasn’t been sold, your total annual operational cost may not rise, but your hourly labor/overhead cost per job does increase. That means lowering your selling prices during slow times hinders your ability to recover your annual operational costs or earn a profit.
• True profit can be lowered as long as you still have the opportunity to recover your true cost.
• In order to lower your cost, you must be certain of your true costs and your cost/profit margin relationship. It is extremely unwise to sell your services below your true cost bottom line.
Thank you, Vito, for bringing up a good question. If any of you have contracting business questions, send them to me. Your questions allow me to address that about which you are concerned. In turn, our noble industry improves for those who read the articles and change their modus operandi.
Contractors that I have coached and who have understood and properly implemented my theories and methods have increased their revenue by, minimally, between 30% and 70%. If you have any questions about my coaching programs, give me a call at 845/639-5050.