True Costs of Doing Business

By Michael Bohinc & John ZinkCover of True Costs Guide

According to recent reports from Profit Cents™ analysis of financial statements of plumbing-heating-cooling contractors, the national industry average net profit was 3.27% for 2010. Why are there such low-profit figures in the industry? Easy answer: Contractors are not properly calculating the pricing for their services based on their actual costs.  

The mathematical equation for calculating a proper selling price includes the following:
• Material costs (M)
• Labor costs including payroll taxes and benefits (L)
• Overhead costs including owner's salary (O/H)
• Profit (P)

The equation looks like this:
SP (Selling Price) = M + L + O/H + P 

Materials costs are easy - just look at what you are paying your suppliers. For the rest of the items, we have to do a bit more work.

Calculating Direct Labor Costs
What costs besides wages go into employee costs?
Employment Taxes - Social Security, Medicare, FUTA, SUTA, Worker's Comp, etc.
Employee Benefits - Paid time off, holidays, sick days, insurance, retirement, uniforms, etc.
A careful analysis of each of the items above is needed to get a solid number for your direct labor costs.

Calculating Overhead Costs
For many contractors, it’s easier to give examples of overhead expenses than it is to define the term. Overhead expenses are those expenses incurred by the business whether or not a job is sold. They are costs that can’t be assigned to any specific job. They don’t directly relate to the providing of a service or the installation of materials. They are the costs to maintain the business even if you weren’t doing any work. They are sometimes also called operating expenses or indirect expenses.

You can’t directly charge a customer for repairs made to a service truck. If the transmission in the service truck breaks in Mrs. Brown’s driveway, you can’t charge Mrs. Brown for the cost of the truck repair because it broke down in her driveway. You have to spread that repair cost (as well as all of the other overhead costs) over all of your jobs (all of your customers). Each customer should pay for a portion of the repair via the overhead component of your break even cost per billable hour. 

Overhead expenses include things like the owners’ salaries, office rent/mortgage, utilities, advertising, office supplies, permits, equipment repairs, employee training, etc. Detailed breakouts can include several dozen line items.

However you break them out, ALL your costs must be collected and counted in the three buckets - Materials, Direct Labor and Overhead.

Identifying & Calculating "Billable Hours"
A billable hour (BH) is an hour that someone works that is actually chargeable to the client. For example, you spend an hour at Mrs. Smith’s house replacing her garbage disposal. That hour is chargeable to Mrs. Smith and is, therefore, a billable hour.

The average 40 hour work week equates to 2,080 work hours a year, but it is not possible to be doing billable work for every one of those hours. Besides the holidays, vacations and sick leave we already mentioned, there will be hours spent driving to the jobs, picking up materials, pricing estimates and doing take-offs from blue prints, attending industry conventions and seminars on technical and business topics, etc. These all subtract hours from the total hours available.

Develop a plan to track your company's average billable hours so that you can be sure that your costs are being divided properly against the hours you have available to bill your customers.

Computing the "Break Even" Cost on a Billable Hour Basis
Recall the selling price equation from an earlier section: SP (Selling Price for Labor) = L + O/H + P

That’s the equation for determining the selling price for a billable hour of labor (not for determining the break even cost for the company), so remove profit from the equation, and we get this for the break-even equation:

Break Even Cost per Billable Hour = Labor cost per billable hour + O/H cost per billable hour 
               BE Cost per BH                     = (DL Cost ÷ BH) + (O/H Cost ÷ BH)

Now that we have our break even price, what about adding profit?

Mark-up Vs. Margin Methods
Many small business owners use a simple mark-up technique to calculate their selling price.  They take their costs, add a percentage on top and think they have a sound number for their selling price.  What they don’t realize is that they are short-changing themselves because they have done the math wrong!

Mark-Up: The Wrong Way to Make a Profit
Here is an example of the Mark-Up method on a job with $100 in costs with a 10% mark-up:

Job Costs + 10% of Job Costs = Marked Up Selling Price
  $100 + $10 = $110 Selling Price

The contractor thinks that they are making 10% net profit on the job, but they are not! How do we know?  Just do the math!  What is 10% of $110?  A 10% profit on a $110 selling price is $11, but we are only getting $10 in profit.  That one dollar doesn’t seem like a big deal, until you apply that thinking to the much larger numbers of your sales revenue.

Margin: The Right Way to Calculate Your Sales Price
Here is an example of calculating profit the correct way.  Again, we’ll use the example of $100 in job costs and a desired 10% profit.

Here is the formula:   Margin = ((Profit % ÷ (1 – Profit %)) X Job Costs)
Or in Our Example:    $11.11 =         ((.10 ÷ (1 – . 10))     X $100
            Simplified:    $11.11 = (.1 ÷ by .9) multiplied by $100
    More Simplified:    $11.11 = .1111 multiplied by $100

What does that mean?  To make a 10% profit on a job with $100 in costs, your selling price must be $100 + $11.11 or $111.11. 

And we can prove that we are right:
10% of Selling Price + Job Costs = Selling Price
        $11.11           +     $100   =    $111.11
The 10% profit on a $111 selling price is $11.11.

We have found that extra dollar that was missing from the Mark-Up method!

Computing a Selling Price Based on Billable Hours
We know from the last section that we need to do division to calculate our Billable Hour Selling Price. Here is the formula for calculating a 15% net profit rate:

SP per BH = (DL per BH + O/H per BH) ÷ (100%  – 15% or .85)

If we had $90/hour in direct labor costs and $10/hour in overhead costs and we want a 15% net profit, what would our hourly selling price be?
SP per BH = $90 + $10 ÷ .85
Selling Price per Billable Hour = $117.65

When you calculate your own billable hosur selling price, you may be surprised by how high the number is. Go ahead and double check your numbers, but realize that if anything less than the properly calculated charge per billable hour is paid by your customers, you are losing money on every job. The more hours sold at a lower amount, the quicker a contractor can find themselves in financial trouble. Cash flow can only keep a contractor who does not charge enough to cover his costs open for so long.

Resources Available from the PHCC Educational Foundation:
The True Cost of Running a Business Guide - Available free to PHCC members via an e-mail request.

Overhead & Profit Calculator Software

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