Pricing, overhead tips

Graph: Kevin Kehoe

Even the most astute contractors struggle to understand and manage pricing. There are clear principles you can apply—with some amount of science and art—that can help you handle this more confidently.

The principles are:

• Pricing is a function of item costs (labor and materials) plus a markup and a profit margin.
• All overhead is recovered through markups on item costs (yes, subcontractors too).
• Profit is made by applying a margin to the product of the two above.
• Revenue volume will influence markups. Greater revenue volume can mean lower markups.
• Market pricing (competition) will influence markups. Lower pricing will mean lower markups.

Graph: Kevin Kehoe

Here’s an example of a multidivisional and multiservice business we’ll use to explore the science and the art. There are three steps.

1. Create a budget. Above is my budget for a company with two profit centers and two service lines within each profit center. The overhead of $1.2 million includes all nonfield personnel, facilities, shop, equipment and administrative expenses for the year.

2. Allocate the overheads to determine markups. The allocations are crucial. They are a function of revenue volume as well as the relationship between labor and material cost. Service lines with more revenue should bear more overhead, and services with a higher percentage of material to labor should have less allocated to labor. There is some art to this. You have to run several scenarios to arrive at the right allocations and markups. Once you determine the allocations and splits, the markup is pure math.

3. Apply margins and compare to the market. This last step combines item costs with the item markups plus a desired profit margin to arrive at a labor rate per hour in comparison with the market pricing you feel you know in reality.

Graph: Kevin Kehoe

In my example, it’s clear there are a few pricing issues in reviewing the math to market comparisons. These can be addressed in two ways: 1). By reallocating overhead to produce a more sellable set of markups and margins, and/or 2). By increasing the budgeted revenue in some or all service lines.

This is what I mean when I say that pricing is both a science and an art. If you can apply this type of analysis every year to determine what your pricing should be, you can manage your estimating and sales process much better than just by pure hunch. Secondly, you are halfway to setting up a reporting system to manage actuals and budgets.