Let’s Talk About Overhead

Frank Blau
Contributing Writer

I’ve previously revealed that PHC contractors earned an average of only 2.7% net profit on gross sales before taxes. Evidently, this information shocked quite a few readers, judging by the letters I have received from contractors around the country, as well as conversations over the phone and in person. Typical comments were “sad,” “ridiculous,” “stupid,” “inadequate,” “we ought to have our heads examined,” “what can we do about it?”

What we can do about it, of course, is to educate ourselves to become better businessmen. That is the point of this series of articles, and it’s time to get down to the task at hand by learning one of the most important business skills of all – how to figure markup.

We also ran an exercise titled “Understanding Markup,” to be filled out and mailed in to ShuBee for review. Readers were invited to calculate the selling price of a job in which three key factors were known: 1) material & labor direct costs of $1,000; 2) overhead of 15%; and 3) a desired net profit before taxes of 10%.

We had an overwhelming number of responses, which my friends at ShuBee tell me is an unprecedented amount of audience participation. I believe the large number of responses shows that many contractors are concerned about the lack of profits in our industry.

The worksheet was the same that I have used in putting on numerous business seminars around the PHC industry. In conducting those classes I have found, without fail, that 90% or more of the attendees calculate the wrong answer, and in the vast majority of cases price the job too low.

Of the submitted responses, however, more than ¾ of the responses sent in were correct. Three out of four respondents actually knew what they were doing in calculating markup. I’m rather stunned by this, although it’s a pleasant surprise.

I would like to believe that I’m all wrong with my theory that the vast majority of PHC contractors don’t understand basic markup. Unfortunately, I think there’s a different explanation for why so many of you came up with the right answer.

It’s simply that the people who take the time to read trade articles about business management and participate in the kind of mental exercises represented by our worksheet are among the more astute people in our business. It’s a matter of cause and effect. They know what they are doing precisely because they take the initiative to read and participate in educational programs. (It may also be that some of the correct answers were submitted by people who have attended my seminars and learned how to calculate markup correctly. If that’s the case, I’m pleased that the lessons have taken hold.)

Those of you who sent in the wrong answers are to be commended also. You at least took the time to get involved in reading something pertinent to your business, and if you read this article, from this day forward you, too, will know how to figure markup.
The RIGHT Way to Calculate Markup

The sample problem we presented has these components: known direct cost (labor and materials) of $1,000; overhead of 15%; and a goal of 10% net profit before taxes for this hypothetical job. Visually, the percentages and resulting dollar figures are shown in the above chart.

In Calculating markup, there is a basic principle that you should lock inside your memory forever.

The overhead and profit percentages are percentages of the SELLING PRICE, not the direct cost of purchase price.
The most common mistake made is to calculate overhead and profit as a percentage of direct cost, and then add those numbers to the direct cost to come up with a selling price. This results in selling prices that are too low. Instead, you have to first determine selling price before you know what your overhead and profit dollars will be. Here’s how it’s done.

Given are the overhead and desired net profit percentages, 15% and 10%, respectively. Simply add them together and you find that these items represent 25% of the SELLING PRICE, which is of course 100%. By subtracting 25% from 100% we get 75%, which represents the $1,000 in direct costs that are known in this example. In real life, direct cost of a job will always be “known,” at least in the form of an estimate. (If you have no idea what it might cost you to do a given job, you’re really in a lot of trouble! Some estimates no doubt will miss the mark, but in the long run they had better average out to what you figure, or else you’re in the wrong business.)

We still do not know what the selling price is in dollars, but from this point on we can find out by constructing a simple algebraic formula using proportional ratios, whereby the unknown selling price is represented by “X.” So 75% is to $1,000 as 100% is to X. Here’s how it looks as an algebraic equation:

.75/1,000 x 1.00/x

If we recall our high school freshman algebra, we know to first multiply the diagonals, so .75X = 1,000. To find the value of X we must DIVIDE 1,000 by .75, which gives us $1,333.33. That is the correct selling price.

To find the dollars of overhead and profit, it is then a simple matter of multiplying the overhead and net profit percentages of the selling price. So $1,333.33 X .15 = $199.9995, obviously rounded off to $200 in overhead cost. Our 10% net profit is $1,333.33 X .10 = $133.33. We already know our direct cost of $1,000, and that it represents 75% of the selling price. To check it simply divide 1,000 by 1,333 and we find it does indeed come out to 75%. When we add $1,000 + $200 + $133, the numbers do indeed total $1,333.

Keep these two rules in mind always:

1) Figure profit and costs as percentages of selling price, not direct cost.

2) To come up with a selling price where costs and desired profit are known, you must DIVIDE, not multiply, by a decimal representing some fraction of 1.00. When you divide by a fractional decimal, the result will always be higher then the base number; when you multiply by a fractional decimal, the resulting number will always be less than the base number.

All of this is basic arithmetic. You don’t need to be a mathematics professor to do these calculations. Even if you transpose a couple of numbers, you can catch it by using simple common sense. Example:

Some of you might get confused and make the mistake of dividing 1,000 by .25 instead of .75. In that case, you would come up with a selling price of $4,000 for this job.

If you can sell a $1,333 job for $4,000, then you should be giving the lessons!
The real problems in our industry are caused by those who will never read this or anything else. They are “too busy” to read, or to attend seminars, or to ask questions. They are too busy because they run themselves ragged trying to solve business problems which stem from the fact that, no matter how hard they work, they never seem to make any money! They’re trapped in a vicious circle, and if someone can convince them to take a little time to read what follows, they can break free.

Oops! The correct selling price for the worksheet problem is $1,333.33, or $1,333 when rounded off. The mathematical calculations for the correct answer are shown in the chart above. I’ve included the chart explaining markup for those who might want to clip it out and pin it to a bulletin board or other convenient location just as a reminder. Here we will examine the incorrect answers and evaluate what went wrong.

The most common incorrect answers to the worksheet problem are selling prices of $1,250 and $1,265, which coincides with what I find in my seminars. Since $1,250 is the lowest one commonly calculated, let’s begin by looking at the false arithmetic that causes it.

Reviewing the numbers, we stated that the direct job cost (labor and material) was $1,000, overhead 15% and net profit goal 10%. From that it is very simple to add the 15% and 10% together to come up with 25%, then calculate 25% of $1,000 (1,000 x .25) to produce an answer of $250. That amount supposedly covers overhead and profit, and is added to the $1,000 of direct costs to come up with an erroneous selling price of $1,250

To explain the basic fallacy, I would like to repeat a quote that ran in my November article: “Profit must be calculated as a percentage of the SELLING PRICE, not the direct cost or purchase price.” In other words, to derive the overhead and profit dollars of this hypothetical job, you cannot figure 25% of $1,000 – the direct cost – but 25% of the ultimate selling price, which is unknown so far. Again, refer to the “RIGHT Way” section above to find out how to get the correct selling price, and work out your overhead and profit dollars from there.

The $1,265 wrong selling price was calculated as follows: First, $1,000 was multiplied by 15% (1,000 x .15) to produce an answer of $150, which was added to the direct cost figure to total $1,150. This answer was then multiplied by 10% to come up with another $115, added to $1,150 for an erroneous selling price of $1,265. A little closer to the mark than $1,250, but not much.

A few respondents came up with a selling price of $1,307, not too far from the true selling price of $1,333, but they’re still cheating themselves out of $26 on the job. They followed the correct algebraic principle of dividing $1,000 by the percentage remaining after subtracting the overhead and profit percentages. Their mistake was doing it in two different steps instead of first adding 15% and 10%, and then subtracting the sum from100%. Thus, they divided 1,000 by .85 to come up with an understated overhead cost of $176.47, which they added to the direct cost for a subtotal of $1,176.47. Then they divided that by .90, added the resulting $130.72 to the subtotal for a job price of $1,307.19.

The fundamental mistake in this procedure is that once again overhead and profit are treated as percentages of costs rather than sales. Examine any financial statement and you’ll find gross sales. i.e. cumulative selling prices, as the first line item entered. All subsequent cost and income percentage breakdowns will be stated as a percentage of sales, not costs.

Other wrong answers on the worksheets ranged from $1,275 up to $2,200, and I have no idea how they came about. Perhaps due to some simple mistakes in addition and subtraction.

The Upshot: The unfortunate result of a $1,250 selling price, compared to the proper selling price of $1,333, is that for every $1,000 of direct cost, a contractor shortchanges himself $83. Instead of a net profit of $133, he ends up retaining only $50. Instead of the net profit target of 10%, he realizes only 3.8% – although he thinks he is making 10%.

This process continues for the entire fiscal year, on job after job. The big surprise comes at the end of the year, when your accountant reveals that your bottom line “stinks,” and you are totally bewildered how that happened. This of course assumes that you have been figuring on 10% net profit on all jobs during the year, and all jobs have gone according to plan. No way!

You get into deeper trouble when your profit goal is in the area of 3-6%, which I know is the mentality of this industry. Let’s run through the arithmetic quickly, using the same $1,000 as our direct cost, 15% for overhead, but changing the 10% profit goal to 3%.

If figured correctly the job should sell for $1,219 plus change. Of that, about $183 would cover overhead and $36 would be your net profit.

However, let’s suppose the contractor made the common mistake of figuring markup in the same way that led to the $1,250 selling price with a 10% profit goal. The erroneous math would be 15% + 3% = 18%. $1,000 x .18 = $180. $1,000 + $180 = a selling price of $1,180. Guess what? He lost money on the job, even thought he thinks he made a little!

I have witnessed these mistakes time and again over the many years I have been in the PHC contracting business, and I estimate that 90% of contractors consistently figure markup too low. In many cases they do not even go through any numbers. They guess at what a correct selling price should be.

As a result, the 10% of contractors who understand how to price a job are characterized as gougers and crooks in the eyes of builders, developers and homeowners. I am one of those 10%, and it “whizzes” met off! It’s just not fair!

How sad indeed that a lack of mathematical knowledge leads to “the blind leading the way” in setting market prices for our industry. I’m convinced it is why we contractors only earn an average of 2.7% net profit before taxes – in a good year – and why salaries for owners and managers are woefully inadequate, as revealed in industry surveys.

Those of us who know what we’re doing can help ourselves and the entire industry by spreading the gospel of correct markups. Maybe a good way to start would be by clipping or copying the section titled “The RIGHT Way to Calculate Markup,” and mail it to the contractors in your market who are “too busy” to learn their business.
Frank Blau is owner of Sudden Service Plumbing in Milwaukee, WI., with more than 40 years experience in the plumbing industry and a founding member of Nexstar Network.


Add a Comment

Your email address will not be published. Required fields are marked *