While he ignored me for about 20 minutes, taking phone call after phone call, I finally fired off a question.
“I noticed that when you quoted that customer a price, you multiplied the cost times 36 percent on your calculator. Is that because you want a 36 percent gross profit?” I asked.
“Yeah,” he said with disdain.
I wrote down his number, then used his calculator to come up with a higher price by dividing instead of multiplying.
“Jim, I’m not very good at explaining mathematical theory, but if you sell the job you just quoted, you’re going to lose about 10 percent. You are not really getting 36 percent gross profit.”
After a few minutes with the calculator, Jim confided that at the end of every year his net profit had been falling a few percentage points short of expectations. “I never knew why the numbers were off until now,” he said.
THE NUMBERS GAMEThe most interesting educational ploy I have ever seen was conducted by Dick Harshaw, then of Carrier Corp. The simple pricing exercise exposes some fundamental problems that contractors often face.
Here is the setup: The total cost of goods sold is $700. The labor is $300. You want a 36 percent gross margin. What is the price? The class then proceeds to ask the instructor all kinds of questions, of course thinking there is some trick. “Is this time and materials or flat rate?” “What about unapplied time?” “Is the labor rate different for installation or service?” The instructor assures the class that there is no trick, but doesn’t provide any hints. At the conclusion of the exercise, there are no less than six different answers from a class of 50 people.
By the way, there is only one right answer. Granted, there are more sophisticated models and some will allow you to apply various rates to time or materials, etc., but this simple equation is enough to identify a common pricing problem.
Here is what usually happens, (Example 1): Many people make the rookie mistake of multiplying total costs by 36 percent to yield $1,360. If that were the correct answer, if you had really “added” 36 percent of profit, then one should logically be able to determine that $360 is 36 percent of $1,360, right? Can’t be done. Thirty-six percent of $1,360 is $490. Uh-oh, something is not right.
SELF-INFLICTED PRICING WOUNDSWhat is not right is that many businesses suffer a slow and painful death. I’ve heard it said that many contractors are simply “going out of business slowly” from self-inflicted pricing wounds. It is like starting each day by purposely giving oneself a paper cut - very painful and not a good indication for one’s mental health over the long haul.
Now, back to the classroom. The instructor points out that $1,562 is the correct answer and demonstrates to the class with some basic math how some of them are actually losing money. In this simple example, if you want a 36 percent gross profit, you should divide by the inverse of .36, which is .64. The difference between $360 and $562 is almost 10 percent in gross profit margin.
My understanding of math is not very good, so do yourself a favor - don’t call me if you need a better explanation of how the numbers work. However, if you believe there may be something wrong with your pricing, call the training department of your local distributor or a manufacturer, or a business consultant who will help you much more than I ever could.