My Two Cents: Setting an Adequate Contracting Pricing Policy
The Formula I Use to Appropriately Establish a Sales Price
Based on the interest in my Feb. 16 column, “Basic HVAC Contracting Budget Accounting,” I thought it would be worthwhile to follow the financial theme a step further and get into pricing policy. This will not be directed at specific pricing numbers, but the procedures we should each go through when establishing our prices.
One might think that determining selling prices would be a relatively easy task once the costs have been determined. However, I can assure you, based on personal experience and some classes I have presented, even the most intelligent and supposedly sophisticated contractors do not always arrive at the selling price they want and intend to use. While this may seem elementary, I encourage you to stick it away some place and refer to it occasionally to make sure you are not skipping an important step. This system applies to whatever your company overhead may be or whatever net profit you are seeking to achieve.
Remember, your overhead percentage is determined by your ability to perform a certain amount of work. If you are going to do less work, your overhead percentage goes up. Unfortunately, when most contractors see there is less work available, they tend to lower their prices. This is exactly the opposite of what it should be because their costs are actually increasing due to a higher overhead percentage.
Step No. 1
List all of the direct-cost items that go into the job. Obviously, this means equipment, labor, materials, and subcontracts. It also should include everything you can directly charge to that particular job. If you rent a man lift or crane, those costs should be directly attributed to that job. An important thing to remember: Anything that can be directly charged to a job should be charged to that job and not to overhead. When inserting labor, be sure to include any and all benefits that are directly associated with the labor on that job. You should accumulate and total all of these direct-job costs. It’s an excellent idea to have a check sheet with every possible direct-cost item you feel you might have on a job and use it to put together this total. That will serve as a reminder to make sure you don’t accidentally forget something.
Step No. 2
From the budget you have already prepared using the aforementioned column, you’ve already determined what your overhead costs are going to be and what net profit you want to average on all of your jobs. The next step is to take that information and use it with your direct costs to determine your eventual selling price. We’re going to use some easy numbers for an example.
In Step No. 1, we determined our total direct costs for this job are going to be $10,000. When we developed our budget, we determined our overhead costs were going to be 25 percent of sales, and we want to have a very good year, so we want to achieve 10 percent net profit. This means that our gross profit needs to be 35 percent in order to cover 25 percent overhead and 10 percent net profit. In order to determine your desired selling price — the part that causes contractors the most trouble — follow this formula:
Subtract gross profit from 1 (1 - 0.35 = 0.65). Then, take your total direct costs ($10,000) and divide that by the number you computed (0.65). Therefore, $10,000 divided by 0.65 = $15,385. This is our ideal selling price. Just to show you that this system works, here is a way to check the numbers: selling price = $ 15,385; less profit of 10 percent = $1,539; and overhead $15,385 times 25 percent = $3,846.
Direct costs were $10,000.
Total: Direct costs $10,000 plus overhead $3,846 plus profit $ 1,539 = our selling price of $15,385.
Step No. 3
The contracting business would be simple if we were always able to sell at the “right” price, as determined in Step 2 above. However, as we all know, in the real world, different situations affect the actual sales price we can obtain. Competitive market conditions, our need for work, and the nature of the job are just some of the factors that impact what we really can use as a selling price. Therefore, we’ve found it useful to make an additional calculation that establishes the minimum amount we can accept when establishing a sales price. Thus, we determine our total direct costs plus overhead. This gives us the minimum selling price we can use before we take money out of our pocket to do the job. Remember, overhead costs are real costs. Reducing our selling price to not cover all of the overhead will eventually ruin the business. In our example, since we know our overhead is 25 percent of sales, we can determine the minimum selling price we can use.
Using the formula above (1 - 0.25 = 0.75), the total direct costs ($10,000) divided by 0.75 = $13,333. Now, we know the range of selling prices we can use. To obtain our desired 10 percent net profit, our price would be $15,389. To cover just direct costs plus overhead with no profit, we could go as low as $13,333. Remember, profit is the fuel that makes our businesses succeed and prosper, so work to obtain your desired net profit number.
It is extremely important to not take any shortcuts along the way. Remember, this all assumes everything goes per plan. I realize this may seem complicated. As a result, I have summarized this on a pricing formula page, which I’ll be happy to send you if you email me at the address shown under my picture.
Proper pricing and knowing how to obtain your proper pricing is the key to remaining in business. In general, your costs and overhead don’t decrease. When you lower your price, all you’re giving away is profit.
Publication date: 5/11/2015