Pricing for Profit

After paying for the costs to run your business and the sticks, bricks, and labor to complete your jobs, you better have some money left over for profit - over and above your salary.

September 04, 2009
September/October 2009
A version of this article appears in the September/October 2009 issue of Home Energy Magazine.
Click here to read more articles about Business Best Practices
Remodelers generally quote a firm price for their work, unless they work on a time-and-materials or cost-plus basis. The culmination of the estimating process is determining the price that we present to the customer in the hope of persuading him or her to buy our products and services. In order to arrive at a price, savvy remodelers realize that they must know more than the cost of the sticks and bricks, labor and subcontractors, that go to make up the project. To determine the proper price at which to propose the job to the client, remodelers must be able to identify two types of cost—job cost and overhead—associated with their particular business and with the particular project. To these two costs they add a third factor, known as profit.

Job Cost + Overhead + Profit = Price

The first factor, job cost, is the sticks and bricks that go to make up a project. Job cost is the sum total of five broad categories of expenses—materials, labor, subcontractors, plans and permits, and cleanup—that are directly related to each individual project. Job costs are bills, employee time cards or subcontractor invoices that include a job address.
The second factor, overhead, is the sum total of the ongoing costs associated with being in business. These costs are not directly related to any particular job. Overhead could include such items as the phone bill, rent, advertising, tools and trucks, or other items of equipment that are used in the production of a number of different jobs.

The overhead calculation is not the result of an estimate. Overhead is calculated by compiling historical information obtained from last year’s checkbook. This holds true except in the case of the remodeler who is just starting out or who is experiencing a rapid change in volume. In either of these cases, the overhead is forecast based on the best available information and monitored closely for confirmation on at least a monthly basis.

Before we present our proposal to the customer, we must add the third factor, profit, to arrive at the price that we will quote for our work. Profit is the just reward for the effort and risk the remodeler undertakes to produce the job. We must calculate all three factors—job cost, overhead, and profit—and total them up to arrive at a price. Only then is the evolution of our estimate complete.

The ability to estimate job cost accurately is one indicator of a remodeler’s level of professionalism. Another indicator is the amount of time it takes him or her to produce the estimate. The best estimators are those who can estimate quickly and accurately in the home, streamlining the entire buying process for the client and saving the remodeler countless hours that are best invested elsewhere.

Identifying Job Cost

Job cost is the sum total of five broad categories of expenses that are directly related to each individual project.

Labor. The cost of labor is the contractor’s cost for compensating hourly employees. It includes both the hourly wage of each employee and additional costs known as labor burden. Included in the labor burden are payroll taxes that the employer is required by law to contribute on behalf of hourly employees, as well as any optional benefits that the employer may provide for employees.

Materials. Cost of materials includes bills from suppliers. It includes not only the cost of the materials themselves, but also such items as sales tax and delivery charges. These bills include a job address where the materials were used.
Subcontractor. Subcontractor cost includes the cost of both labor and materials provided by nonemployees.

Plans, permits, and fees. This category includes costs associated with the act of obtaining a building permit. It includes the cost of physically delivering the building permit application and ‘walking it through’ the building, zoning, and other departments required in the approval process.

Cleanup. The cost of cleanup includes dumping fees and costs associated with hazardous waste containment and disposal, the transportation of waste, and so forth.  

Identifying Overhead

Overhead is the sum total of the expenses, other than job cost, that are required to operate a business.

In the newly established or smaller company, it is not unusual for the owner/remodeler to wear many hats. At some point, he or she may want to hire someone else to do some of these jobs. In order to find out what this will cost, and whether it will be profitable, the owner must compensate himself for every job he performs. For example, if the owner is acting as production manager, salesman, and part-time carpenter, he or she must be compensated at replacement cost for each of those jobs. When the time comes to hire a salesperson, for example, the owner can tell whether it will be feasible to pay a new person at the same rate of compensation. If this can be done, there will be no increase in overhead. The costs associated with adding a new person will simply be shifted from the owner to the new hire, leaving the owner free to devote his energy to the other two jobs.

Established remodelers identify and categorize overhead simply by studying the history of their company, as written in the checkbook. The established remodeler reviews his checkbook for the previous period—monthly, quarterly, semiannually, or annually—and assigns each check that is not a job cost item to one of the several overhead categories, such as rent or lease, advertising, communication, transportation, and so on.

Remodelers calculate total overhead and then figure it as a percentage of gross sales. They add this percentage to the job cost. In this way, they arrive at a sales price that will cover both the job cost and the overhead.

Identifying Profit

Profit is the just reward for the effort and risk the remodeler undertakes to produce the job and operate the business.
The risk-reward ratio dictates that the greater the risk, the greater the reward must be to compensate for that risk. This means that the remodeler must receive a greater reward than the restaurant owner, for example in light of the fact that he assumes more risk in his business.

The remodeling business is one of the toughest businesses in which to succeed. According to a study of Maryland-based home improvement contractors the failure rate in the first five years is 90%. In order to succeed, the remodeler must eliminate as many uncertainties as possible. One of the keys to success is to have a quick and accurate system of estimating, based on scientifically determined, verifiable numbers that identify your job cost, overhead and profit. These numbers can be used over and over, so that it is possible to generate proposals with as short a response time to the customer as possible. The job cost system of estimating provides that key to success.

How to Determine Fair Pricing

The equation we work from to determine the proper price that we will present to our prospect is: Job Cost + Overhead + Profit = Price.

Get out a piece of paper and organize three columns headed Overhead, Job Cost, and Income. Looking back through your checkbook, identify which checks belong in the overhead column and which in the job cost column. Income is easy to spot; the deposits in your checkbook go in the income column.

Now total the items in each column. As an example, we’ll say that your totals for last year looked like this:

 Income     Overhead    Job Costs

 $400,000     $156,736     $231,264

These numbers indicate that your yearly efforts to produce $400,000 worth of remodeling income generated an annual profit (before taxes) of $12,000 ($400,000 - $156,736 - $231,264 = $12,000) or 3% ($12,000 / $400,000 = .03 = 3%).

If you wanted to generate a 10% net profit annually, this would come to $40,000 for every $400,000 of income. To generate $40,000 profit per year, you need to determine the markup necessary to increase your job costs ($231,264) by enough to pay your overhead ($156,736) and leave $40,000 over. In other words, you need to increase your annual job cost by the sum of your overhead of $156,736 plus the desired profit of $40,000.

Remember the equation above:

Job Costs + Overhead + Profit = Price
$231,264 + $156,736 + $40,000 = $ 428,000

Now you need a mathematical shortcut to determine by what factor you need to multiply job costs in order to create a proposed sales price (income). In the following set of equations, X represents the unknown factor.
  1. $231,264 x X = $428,000
  2. X = $428,000 / $231,264
  3. X = 1.85069 (Round this number to two decimal places = 1.85.)
  4. $231,264 x 1.85 = $427,838 (Because you rounded down, your answer is a little smaller than your target of $428,000.)
  5. In this example, you need to markup your job costs by a factor of 1.85 to determine a fair price that will cover your overhead and leave 10% net profit before taxes.

It is at this point that we consider our numbers to be a proposal to the customer. In its final form the price has evolved far from an estimate, having been enhanced by all of the factors that allow us to propose a solid dollar figure for which we will provide the services and products required of the project.  

Mike Gorman is a Certified Remodeler (CR) with the National Association of the Remodeling Industry (NARI), and has held local, regional, and national offices with NARI. He delivers seminars and provides telephone and on-site coaching with clients ranging from Fortune 500 companies to individual contractors regarding sales, marketing, estimating, and systematizing the business. His recent book, If I Sell You I Have a Job, If I Serve You I Create a Career! has filled a void in sales training for remodelers and custom home builders.

For more information:
1543 U.S. Hwy. 98, Ste. 209 Lakeland, FL 33801
Tel: (1-800)218-5149
Fax: (413)845-2169

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