What You Don't Know Can Really Hurt

October 9, 2006
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Do you know your new residential construction sales, replacement sales, or service sales for the past month or the past year? Do you know the overhead in your service department?

How about the overhead in your replacement department, or maybe your residential new construction department, or for that matter all the departments that you do business in? Do you know your average gross margin percentage in all those departments mentioned above? Do you know how much you either made or lost in each of those departments?

Sad to say, but most of the industry - I believe it to be about 90 percent - does not know the answers to any of the above questions. If you answered, "I don't know," or "I can come close," the bad new is you belong in the 90 percent.

Figure 1: Without all the proper information it can be difficult to price out jobs. This chart displays an example of Ligon's simple pricing strategy for contractors. (Click on the chart for an enlarged view.)

BUSINESS IS BUSINESS

I think it is fair to say that without this information most of us aren't running our businesses like businesses. A real business owner can answer all of these questions with a yes.

It seems without all the proper information it would be difficult to price out jobs. If you are in the 90 percent who don't know all the facts, how can you calculate the correct selling price for jobs?

To make things complicated we could discuss high labor content jobs or high material content jobs and then solve the pricing problem using dual overhead factors. If you know those factors, then it is safe to say you are not in the 90 percent.

Assuming taxes are paid at the time of materials purchase, a properly priced job would include the cost of goods, the 35 percent replacement department overhead, and the 10 percent desired net profit before taxes. Solving the pricing puzzle can be as simple as dividing the cost of goods by 0.55.

Once the correct selling price is determined, calculate the percentage for replacement department overhead and then the percentage for desired net profit. Totaling the three figures should verify the previously calculated correct selling price. (See Figure 1.)

The divisor method can also be a good method to use.

Figure 2: For each job contractors price, they must keep in mind the gross margin percentage. Profit is made when the gross margin is larger than the overhead percentage, as seen in Ligon's example here. (Click on the chart for an enlarged view.)

WATCH OVERHEAD

Contractors can estimate the cost of goods sold. That is to say they can accurately figure the equipment and material prices for individual jobs. We can estimate the direct labor subcontracts, warranty reserve, and the permits. We can even definitely decide how much profit we would like to make on the job.

So what is missing here? Of course, for the 90 percent guys, it's the overhead percentage. If we don't know that percentage number, then we are just guessing. If you are in the 90 percent, you don't know your overhead. If you don't know your overhead, you cannot calculate the correct price.

The concept of correct pricing is pretty simple. In each job you price, the gross margin percentage must be larger than the overhead percentage. If it is larger, then you show a profit, if smaller then you show a loss. (See Figure 2.)

Bottom line is this: You must departmentalize your business by residential new construction, replacement, service, IAQ, and on and on. Because each department has a different and distinct overhead, you must find each department overhead to arrive at a correct selling price for that particular department. The good news is that you can learn how to answer all those questions in the affirmative.

Publication date: 10/09/2006

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