One Bite at A Time
How to apply a proper profit margin.
DZ, a contractor from North Dakota, asks: “In the latest issue of PHC News, you talk about ‘per hour.’ but what about makeup of parts? Do you not charge markup, and only use labor as profit? I use labor and parts markup. For example, service labor is $75/hour, and parts markup is based on time it would take to replace it under the labor warranty period. For example, a relay is probably $45 markup to cover actual expense of warranty replacement, but install labor is $60/hour and 40 percent across the board on material. These install jobs have more billable hours due to the longer term nature of install projects.”
It’s said the best way to eat an elephant is one bite at a time. First, allow me to address service labor. The reason I use the term “per hour” is that all contractors, whether they use time and material or contract pricing, calculate their labor costs in terms of the time to perform a task. That time could be in years, months, weeks, days or hours, but the common denominator is always hours and fractions thereof.
Contractors who use a T&M pricing method to calculate their price, based on the time and material they spent on a task, multiply the time spent by their hourly rate, which hopefully includes a proportioned amount for overhead costs and profit. Add that number to the selling price for material used, which includes the cost of the material and a markup above that material cost.
The problem with T&M pricing is that the consumer doesn’t know the cost they will incur until the task is completed. Obviously, this could lead to an uncomfortable confrontation when the final bill is presented and the client gets hit with sticker shock after the task is performed. In which case, an enforceable contract between the contractor and consumer may not exist since there was no “meeting of the minds” of the parties involved.
With contract pricing that is quoted and properly documented before the task is started, the propensity for an argument to ensue after the task is performed is greatly diminished since the consumer knew the price before the task commenced. As long as contractors fulfill their obligations under the contract, consumers must pay the amount agreed upon.
With T&M pricing, your every move is critiqued by the client. “Why is it taking so long?” “Why does the tech keep going back to their truck?” “Why are they going to the bathroom on my time?” With contract pricing, those types of questions don’t arise because the price you and the consumer agreed upon is a known factor.
Regardless of which you use, one thing is certain: You must apply the proper numbers since wrong numbers can only produce wrong results.
DZ’s example states service labor at “$75/hour.” He then states that install labor is “$60/hour.” That sounds confusing. Which is it? To me it seems that he believes his cost for labor is $60/hour, and his selling price of labor is “$75/hour.” In either case, he’s using wrong numbers. For the umpteenth time, allow me to state, at present give or take a 5 percent variable, there is no place in the U.S. where the true cost (to contractor) of a qualified service tech in a properly outfitted service vehicle is less than $100 per hour — if that business sells all their tech hours all the time.
Think about that statement. If you paid a tech $25/hour and minimally added 25 percent to that number to cover salary related expenditures (e.g. FICA matching funds, retirement, and, insurances for unemployment, disability, worker’s compensation, liability related to payroll, and health), the cost per hour would increase to $31.25.
You would pay that hourly rate for 2,080 hours annually (40 hours/week x 52 weeks). If you lost just one hour per day to non-revenue producing tech duties, allow two weeks for vacation/personal time and six holidays, you would only have a maximum of 1,708 potential hours to recover your cost. That means the $31.25 is really $38.06 per revenue producing hour, if you sell all your hours all the time ($31.25/hour x 2,080 hrs. = $65,000, but $65,000 ÷1,708hrs. = $38.06/hour.)
Now consider the fact that no contractor sells all their available tech hours all the time. If you only sell 90 percent of tech time, the hourly cost rises to $42.28. At 80 percent of tech time sold, it becomes $47.57. Only sell 70 percent (which is probably average during good economic times) and the hourly cost to contractor rises to $54.37. As economic times get worse (remember the last eight years) and you only sell 60 percent of tech time the costs continues to rise to $63.43. At 50 percent of tech time sold, the cost jumps to $76.11.
Each of those levels do not include the overhead burden associated with business operational costs. Since overhead exists for all businesses, the costs associated with overhead must be calculated to arrive at your true cost. Regardless of the size of your business, you still have to pay for: vehicles and vehicular expenses; space for business operation; administrative expenses; and a myriad of miscellaneous expenses e.g. phones, computers, office supplies, tools, bank charges, customer relations, advertising, professional services such as accountants etc.
Those overhead items minimally cost $75 to $150 per tech revenue producing hour — if you sell all your hours all the time. When you add the minimum $75 overhead burden to the lowest aforementioned labor cost of $38.06, you have a cost to contractor of $113.06 — if all tech hours are sold all the time.
If you don’t believe your overhead is minimally $75/tech hour, you are probably cheating yourself. But, even if you subtracted $15/hour from the $75 minimum hourly overhead burden, the cost of service labor per hour would be $98.06. Therefore, DZ’s example of a $75/hour rate is wrong, and the results he gets using that factor cannot get him to attain the goal of any business — to bring in more money than it costs to run the business.
Therefore, the first number you must be concerned about is the true cost you incur for labor and overhead. The second factor is the profit margin that will get you where you want to go. This requires that you know the difference between a markup on cost and a profit margin.
Markup on Cost Example: If labor, overhead and material cost is $200; if you sell all your tech hours all the time; and if you mark the cost up by 10 percent, your selling price would be $220. ($200 x 10 percent = $20. By adding that $20 to the $200 cost, you get a selling price of $220/hour). Your profit is $20 if all tech hours are sold.
Profit Margin Example: If labor, overhead and material cost is $200; if you sell all your tech hours all the time; and ifyou use a 10 percent profit margin, your selling price would be $222.22 ($100 ÷ 90 percent = $222.22). Your profit is $22.22 if all tech hours are sold. To maximize your profit, logic suggests using the profit margin method. The question you must answer is which percentage to use to get you where you want to go.
If your hourly tech cost is the minimum $100 based on selling all available tech hours, but you sell only 70 percent of your available tech time, the $100 cost to you per tech hour would really be $142.86. This risk factor must be considered in choosing a proper profit margin percentage. In this example, you need a 30 percent profit margin to just break even ($100 ÷ 70 percent = $142.86).
As to DZ’s inquiry, “But, what about makeup of parts? Do you not charge markup and only use labor as profit?” I do not apply a markup on cost method. I apply a profit margin to my cost of labor, overhead and material needed to perform any task. Then, describe the task to the consumer and quote the selling price to the consumer in writing before the service is commenced.
Let’s take a look at DZ’s example of a relay. The basis of the cost of this example is: 1) $112.50 cost to contractor for the relay (DZ’s $45 markup on material cost ÷ 40 percent markup on material cost = $112.50); 2) all material is on the service vehicle; 3) Two hours of labor at the minimum $100 cost to contractor — if all tech hours are sold all the time — to perform the task inclusive of: Travel time to consumer; speaking with the consumer; quoting the selling price; writing an invoice/contract; asking the consumer to accept the contract and its terms and conditions by signing the contract; setting up the work area with tools and material; removing the existing relay; installing the new relay; turning the heating system on and checking it through cycle to ensure all safeties are functioning properly before leaving; getting paid for the service; cleaning up the work area; thanking the client for their patronage; and leaving; and 4) application of a 40 percent profit margin (your percent varies dependent on your situation) to the labor, overhead and material cost.
Since no contractor incurs a cost of less than $100/tech hour if they sell all tech hours all the time, DZ would minimally incur a cost of $200 for labor/overhead plus a material expense of $112.50. DZ would incur $312.50 to bring in $307.50 to his business. That’s a $5 loss — if he sells all tech hours all the time. If he sells less than 100 percent of his tech time, he loses more yet.
The answer to DZ’s question: Choose a proper profit margin and apply it to your true cost of labor and overhead and also to your material cost to develop properly profitable selling prices. It’s as simple as that.
To you, DZ, and to all contractors who want an opportunity to attain their contractor profit advantage, need my assistance, have an opinion on this article, would like information on the ways I can help you, or would like to order a copy of my Readily Available Pricing Information Digest pricing guide which is customized to your true cost of labor and overhead an, puts prices at your fingertips for rapid and profitable price quoting, give me a call. The initial call doesn’t cost you anything, and, you just might discover some good ideas. l
Richard P. DiToma has been involved in the PHC industry since 1970. He is a contracting business coach/consultant and an active PHC contractor. For information about the Contractor Profit Advantage or to contact Richard: call 845-639-5050; email email@example.com; mail to R & G Profit-Ability, Inc. P.O. Box 282, West Nyack, N.Y. 10994.