How Much Should You Charge to Earn a Profit?

October 4, 2000
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Over the years, I have seen many hardworking contractors who don’t price their jobs or their services so that they make a real profit. They think that they are, but when they get their financial statements they’ve worked for wages or are losing money — even though they are working hard.

I have developed a series of rules that you can use to ensure that you will price your jobs and services so that you make a profit. Using these rules, you can also “what if” yourself to death. For example, you can find out how much you need to sell if you raise your overhead by 5%, want to hire a parts runner, or add production personnel.

A Little Background

Before I begin the rules, I need to make sure that everyone is on the same page with respect to the terminology that I use.

First, let’s look at the income statement. The income statement is also called a profit and loss statement. I define the income statement as sales minus cost of goods sold (or direct cost) equals gross profit. Gross profit minus overhead equals net operating profit before taxes. I define cost of goods sold or direct cost as any expense that you have because you sold something. All production labor needs to go into cost of goods sold, as well as commissions, spiffs, etc.

Only the materials used on the jobs go into the cost of goods sold. If you get a preseason order, it is inventory until you use it on the job. Other normal costs of goods sold include expenses such as warranty, freight, permits, subcontractors, etc. Some contractors put truck expenses in cost of goods sold; some don’t. All that matters is that you are consistent. (This means that if you are going to include truck costs, include them all the time.)

Overhead items are those expenses that you incur to keep the doors open. These include rent, utilities, owners’ salaries, etc. You pay overhead whether you sell one dollar’s worth or not. These expenses continue during good and bad months.

For the purposes of the Ruth’s Rules calculations, I stop at net operating profit, because there are always extraordinary things that can happen which affect the bottom line. You could have a great year and give bonuses. You could sell used trucks. You could get interest income from investments.

These occurrences result in dollars that you pay out or receive, and obviously they affect your bottom line. However, they are not revenues and expenses that occur regularly, so they don’t count in the day-to-day transactions that you do to make a profit and that you base your pricing on. Yes, they do count at the end of the year. However, they are extraordinary events that should not be taken into consideration when you price jobs.

The other important Ruth’s Rules term is gross margin. Gross margin is gross profit divided by sales. The difference between gross profit and gross margin is that gross profit is always a dollar amount. Gross margin is always a percentage. You must watch the gross margin for each of your departments. It should remain fairly constant (within 1% to 2% each month) whether you are slow or busy. Your gross margin will tell you whether you are pricing your jobs right and how much unbilled overtime affects your profits, as well as whether you are accounting for your inventory properly.

The first rule has to do with selling price when you know the direct costs for the job. The second rule determines break-even sales, and the third rule determines sales at a specific net profit level.

Ruth’s Rule No. 1

The first rule tells you how to price a job or a service ticket when you know the direct costs for that job or service ticket.

Ruth’s Rule No. 1 is selling price equals direct costs divided by (1 minus gross margin). Remember that 1 is 100% and that gross margin is always a percentage. The reason that you divide by 1 minus the gross margin has to do with the structure of the profit and loss statement. The first part of the profit and loss statement is sales minus direct costs equals gross profit. Sales equals the total selling price for the job. The sales represent 100%, or the total revenues for the job.

Gross margin, by definition, is gross profit divided by sales. So, the gross margin is the percentage of sales that you have left after you take out your direct cost percentage. Using simple mathematical formulas to arrive at the selling price when the direct cost is known, you have to divide by the direct cost percentage (or 1 minus the gross margin).

Let’s take a simple example. A service technician spends 2 hrs on a job. He uses $50 worth of materials. His hourly rate is $15/hr. You want to achieve a 55% gross margin on all service calls. What price should you charge the customer?

The total cost for the job is $50 in parts and $30 in labor ($15/hr x 2 hrs). The total cost is $80. To get the selling price, divide $80 by 45%. You should charge the customer $177.78.

For those of you who include labor burden in direct cost, let’s refigure the example. Assume that the cost of payroll taxes, health insurance, worker’s compensation, etc. for this employee is 33% of his hourly rate. This 33% comes to $9.90. So, the total cost for the job is $89.90. If you charge the customer $177.78, as in the example above, this time your gross margin is approximately 49.4% rather than 55%.

For those of you who include labor burden and truck costs in the direct cost, let’s again refigure the example above. Assume that truck cost is $10/hr. Then, the total cost for the job is $89.90 plus $20 for the 2 hrs he’s on the job, or $119.90. If you charge the customer $177.78, as in the example above, this time your gross margin is approximately 32.6%.

These examples show that depending on how you define direct cost, your gross margin can vary from 32% to 55% with the customer being charged the same price. Of course, the overhead percentage is a lot higher with the first example than it is with the last example.

So, how do you determine your gross margin? It actually depends on knowing your overhead percentage and the net profit that you want to achieve. These topics are covered by rules No. 2 and 3.

Ruth’s Rule No. 2

Ruth’s Rule No. 2 is break-even sales equals overhead divided by gross margin.

Some of you are probably thinking, “Wait a minute. Above you told me to divide by 1 minus the gross margin. Now you are telling me to divide by the gross margin.” That’s true. In the first instance, we knew direct cost. Now we know overhead cost. That’s the difference.

Let’s take an example. Suppose your salary is $100,000 and you want to know what the company has to sell to just break even on your salary. When you get your financial statement you see that the company’s gross margin is 35%. Using Ruth’s Rule No. 2, divide $100,000 by 35%. You get $285,714.29. This means that the service technicians, installation crews etc. have to generate $285,714.29 just to cover your salary.

Let’s check our answer using the income statement. Remember the formula for the income statement is sales minus direct cost is gross margin. Gross margin minus overhead is net profit before taxes.

In our example, the sales we have to generate are $285,714.29. Our direct cost is 65% of those sales. (Since we have a 35% gross margin, the direct cost has to be 65%.) So our direct cost is 65% times $285,714.29 or $185,714.29. Subtract: $285,714.29 minus $184,714.29. The gross profit is $100,000. Since the overhead (i.e., your salary) is $100,000, the net profit is zero and you’ve just broken even.

This rule is very helpful when you want to add an overhead position. For example, if you wanted to hire a warehouse person, this formula lets you know how much additional revenues the company would have to bring in (or the savings that this person would have to create when hired) to cover the new position.

Let’s say that you will pay the warehouse person $10/hr or $20,800/yr (without overtime). If you assume that his benefits cost another 33%, his compensation package totals $27,664. Let’s round this to $28,000 per year. If this person is also going to be responsible for parts deliveries, add a year’s truck cost to the $28,000. For this example, I’ll assume that the person will remain in the warehouse. Let’s assume that the company gross margin is 35% as in the example above.

The additional revenues that the company would have to generate or dollars that he would have to save come to $28,000 divided by 35%, or $80,000 per year.

Can a warehouse person save $80,000 per year? Easily. If this person gets the crews’ materials ready, and they spend an additional hour per day on the job rather than searching for parts, the warehouse person pays for himself. If three service technicians can do an extra call per day, then that is an additional $75,000 in sales (assuming the average service call ticket is $100 for 50 weeks) so the warehouse person pays for himself. I know of companies with only 5 people, where one of the people is a warehouse/parts runner who pays for himself just in saving time and letting the revenue-producing people produce revenue rather than waste time that can’t be billed.

Ruth’s Rule No. 3

Ruth’s Rule No. 3 is sales equals overhead divided by (gross margin minus the profit percentage).

I assume that all of you want to do more than just break even. Ruth’s Rule No. 3 tells you how much you have to sell to achieve a preset net profit with a given amount of overhead and gross margin. Ruth’s Rule No. 3 is used for planning your job, your month, your quarter, or your year. Here’s an example:

You are budgeting the service department financials for next year. You see that your gross margin for the service department is 50% and your overhead for the year is estimated to be $500,000. To achieve a net profit of 10% in the service department, how much does the service department have to generate?

Using Ruth’s Rule No. 3, sales equals 500,000 divided by (0.50 minus 0.10), or $1,250,000.

What would happen if you set the goal to increase the service department gross margin to 55%?

Using Ruth’s Rule No. 3, sales equals 500,000 divided by (0.55 minus 0.10), or $1,111,111.

A 5% increase in gross margin means that the service department has to generate about $140,000 less to achieve the same profit level. This is the approximate revenues that one technician should generate. So, a 5% increase in gross margin means you need one less technician, if the other assumptions are true.

Let’s look at an example similar to the ones above. Suppose your salary is $100,000 and you want to know what the company has to sell to earn a 10% profit (rather than just break even) on your salary. When you get your financial statement you see that the company gross margin is 35%. Using Ruth’s Rule No. 3, divide $100,000 by (35% minus 10%). You get $400,000 (rather than the $285,714.29 calculated above). This means that the service technicians, installation crews, etc., have to generate about $115,000 more than in the above example just to cover your salary.

Let’s check our answer using the income statement. Remember the formula for the income statement is sales minus direct cost is gross margin. Gross margin minus overhead is net profit before taxes.

In our example, the sales we have to generate are $400,000. Our direct cost is 65% of those sales. (Since we have a 35% gross margin, the direct cost has to be 65%). So our direct cost is 65% times $400,000, or $260,000.

Subtract: $400,000 minus $260,000 is $140,000. The gross profit is $100,000. Since the overhead (i.e., your salary) is $100,000, the net profit is $40,000, which is 10% of $400,000.

These are the three rules that I use to calculate selling prices when I know either direct cost or overhead cost and gross margin. The way that I usually work the process for Ruth’s Rules No. 2 and 3 is to look at the percentage of profit that I want to make, and knowing the overhead, I determine what the gross margin has to be to achieve a certain level of sales. Then I look at the result and see whether it is realistic — or achievable. That’s how I plan budgets for the contractors I work with and that’s how we look at pricing issues.

Spend some time to get familiar with these rules. I think that they will help you price your jobs accurately as well as plan your budgets. King, of American Contractor’s Exchange, may be reached at 800-511-6844; 770-729-8028 (fax); or www.acecontractor.com (website).

Publication date: 10/09/2000

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