# overhead and profit



## ruskent (Jun 20, 2005)

Dirt explain to us how knowing how to be profitable is more important then good estimating. Because as far as i am concerned, good estimating leads to profitabilty. A good estimator will estimate base on the companys production speed, overhead, and profit requirements.


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## Jerrald Hayes (Apr 24, 2006)

Late last week and over the weekend I received a couple of emails from some folks who were reading what I think was this discussion here on CT asking me for clarification on some of the things I written and asked me to speak up regarding debate between using a Capacity Based Markup vs. a markup strategy that is based on predicting your yearly total dollar (labor, materials and subcontracting) sales volume (i.e. a Uniform Percentage Markup) .

While I think the markup methodology described in the book Markup & Profit is better than no methodology at all there are some real big huge problems with it that especially in the tight competitive market like we are in today could cause a contractor a lot of financial problems. 

In his book * Running a Successful Construction Company* writes about markup in Chapter 5 Estimating and Bidding on pgs 167 through 168 and in two sidebar blocks on pg. 167 writes specifically about the danger of using a Uniform Percentage Markup: *The Google Books Excerpt*.

I've also written about this twice in my own blog in "One of the Potential Problems in Using a Traditional Volume Based Markup" and more recently "Comparing Markup Methodologies In Real Some World Pricing Scenarios" where I illustrated scenarios which show how contractors using Uniform Percentage Markup will find themselves underpriced and will lose money on jobs where there is a '_High Relative Cost of Labor to Low Cost of Materials, and SubContracting_' and will find themselves overpriced and priced out of the market on jobs where there is a '_Low Relative Cost of Labor to High Cost of Materials, and SubContracting_'.

While I think Michael Stones book is generally a good book every contractor should have on their shelf I think Gerstel's book and Ellen Rohr's book * How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love* provide far better safer and more robust guidance regarding markup.


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## Jerrald Hayes (Apr 24, 2006)

T. D. G. said:


> ...Can some one tell me the best way to lets say to put a price together for a home improvement project that will last two weeks for my company. There is a local permit involved.
> The materials with tax will be $10,000
> The labor costs total will be $ 7,000
> 
> ...


 T. D. G. I've looked at the numbers you've published in your initial post here and I now have a couple questions for you before I give you my take on this.

$20,500 a year (or $1708.33 per month) while realistically possible for a one person operation sounds a little on the light side to me. Just what do you consider to be your overhead costs? I am thinking I can infer from your comment. "_I know what profit is, but how much to charge on each project bid._" that you have not included any Net Profit in that calculation.

That said going on the assumption that that number is the correct figure for your business I would then take that number and divide it by 50 to come up with a weekly overhead allocation number you need make. I divide by 50 rather than 52 figuring as DavidC did that you will want to take off from work a least 2 weeks of time over the course of a year and come up with a figure of $410.

Now taking the next step looking at your your estimated labor costs for this 2 week project I'm wondering just what does that $7,000 figure represent? Is that one company employee working two weeks (80 hours) at a stratospheric COST of $87.50 per hour or is that three employees working for two weeks at a perhaps more realistic COST of $29.16 per hour.

The reason I ask that is because I have seen contractors in other forums develop a Capacity Based markup Loaded Labor rate (which is a labor rate that takes into consideration, an is thereby "loaded with" all the Variable Overhead and Fixed Overhead costs and Net Profit associated with a unit of labor. I.e. wage/salary + benefits + overhead costs + profit margin) and then multiply that figure by 1.5 Uniform Markup multiplier they're read about in Michael Stones book which essentially has them double dipping for their overhead and profit and they come up with a ridiculously high figure which of course would be rejected.

I am going to assume your labor figure represents something more like the three employees working for two weeks at a cost of $29.16 per hour or even two employees working for two weeks at a cost of $43.75 per hour. Given the wide disparity of labor costs nationwide both those scenarios are potentially realistic depending upon what part of the country you are talking about. 

Actually all my labor cost figure questions are something of a moot point. If the job took two weeks of your company's time you need to charge two weeks of overhead costs to it. Period. 2 x $410 = $820.

So Labor Cost of $7,000 + Company Overhead Charges of $820 + Materials Costs of $10,000 = $17,820 (but as I said before that Overhead figure sounds a little weak to me).

That said however none of figuring so far that includes anything for Net Profit which is the dollars you want left over after every single thing, job costs and overhead are paid for. How much Net Profit you want to make is really something of a subjective number. How much do you want to make? In figuring your target for Net Profit keep in mind that while Uncle Sam allows you to deduct a lot of your costs of doing business this is the figure he takes his cut out of. So when you figure for what you want to make above and beyond the wage and/or salary you pay yourself you need to figure for his cut too.

So while what is an acceptable amount of Net Profit to make is a worthwhile discussion in its own right there are basically two ways of approaching how to look at it. You can figure a target as a percentage Return on Equity or you can target a percentage of your total volume.

I like and often refer to George Hedley's take on the subject which is about your Return on Equity: *How Much Profit Is Enough*. In it Hedley writes:



> —"If asked to invest $100,000 in a friend’s new start-up business, what return would you want? 10%, 15%, 25%, 50% or More? After considering all the risks, I would never invest in a new business that didn’t offer at least a guaranteed 15% to 25% return on equity or capital. Likewise, the minimum pre-tax net profit goal for your company should be 15% to 25% return on equity (or higher)."—


Working with Hedley's ROE thinking let's say you have a modest $60,000 worth or Equity in your business. 20% of that works out to a desired $12,000 return on your equity which divided by 50 weeks equals $240 per week. Times the 2 weeks you expect your project to take that adds on $480 for a total project cost of $18,300. 

On the other hand on pg. 186 of his book Markup & Profit: A Contractor’s Guide Michael Stone says "You should be making a minimum of 8 percent net profit" " but there’s really no reasoning or discussion on it beyond that sentence. And I feel I can safely say he is referring to 8 percent of your total volume. That just seems way too low a target for any almost any kind of business. Sure there are some mega huge high volume contractors who work with even smaller percentages than that but (and I really hate to say this) they do make it up on volume. Besides if you target 8 percent you will probably hit on 4 or 5 and actually only pocket 1.5 to 3.5 after Uncle same takes his cut. 

Conservatively thinking I think a target in the range of 10-15% is a far better idea. Ellen Rohr recommends 20%, and while Gerstel never actually recommends a target Net Profit percentage in an example he uses on pg. 95 the company he citing earns a 14.28% Net Profit. Gerstel does however talk about a number of key ratios to look at towards the end of Chapter 3 Going Deeper into Your Numbers to evaluate how well you company is doing with its Net Profit earnings.

Still this is where the quality in the mind of your customer of the service product your company delivers is critical. The better they view your company the higher Net Profit you can call for and achieve. I think most contractors just getting started with an estimating and pricing system should shoot for a Net Profit in the range of 10-15%.

For what its worth though I think there is a far simpler way to deploy a Capacity Based markup strategy than having to go through the mathematical gyrations I just described here with each and every project.

Sit down and develop loaded labor rates for you and all your employees have your overhead costs and Net Profit on your company's labor built into it based on the methods described in Ellen Rohr's book and/or google the Capacity Based Markup Worksheet use that as a guide.

Then estimate the number of labor hours the tasks in your project will take and multiply the hours for those tasks by the loaded labor rate for the personnel you expect to have doing the work. 

Then add an appropriate contingency buffer of hours to protect the whole project from what you might be off in your task hours estimating and multiply that by your median or average loaded labor rate. Its a whole other discussion but you don't pad the individual tasks with contingencies since it is unlikely that every task will run as a worst case estimate and padding for that would unnecessarily bloat your time estimates and labor cost quote.

Then with regard to your materials and subcontracting assuming you have included the time involved in acquisition and delivery of the materials and supervision of the subs into your company's labor estimate I would add a percentage to each of those cost figures that I would want to have my company earn as a Net Profit for "selling" those products (the materials) and services (the subcontracting) to my customer.

Keep in mind however that if you lets say want to earn a 10% Net Profit on your Materials you can't just add on 10% (multiply by 1.1). That will only earn you a 9.1% net profit. You'll need to multiply by 1.11 to earn a 9.9% Net profit (and I think that's close enough). See the list below for typical Net Profit Markups

A 1.07 markup will return a Net Profit of 6.5%
A 1.08 markup will return a Net Profit of 7.4%
A 1.09 markup will return a Net Profit of 8.3%
A 1.10 markup will return a Net Profit of 9.1%
A 1.11 markup will return a Net Profit of 9.9%
A 1.12 markup will return a Net Profit of 10.7%
A 1.13 markup will return a Net Profit of 11.5%
A 1.14 markup will return a Net Profit of 12.3%
A 1.15 markup will return a Net Profit of 13%
A 1.16 markup will return a Net Profit of 13.8%
A 1.17 markup will return a Net Profit of 14.5%
A 1.18 markup will return a Net Profit of 15.3%
A 1.19 markup will return a Net Profit of 16%
A 1.20 markup will return a Net Profit of 16.7%
A 1.21 markup will return a Net Profit of 17.4%
A 1.22 markup will return a Net Profit of 18.%
A 1.23 markup will return a Net Profit of 18.7%
A 1.24 markup will return a Net Profit of 19.4%
A 1.25 markup will return a Net Profit of 20%

While I generally recommend against doing T&M work when you can give lump sums using this method you then at least have a loaded labor rate in place that you can quote and apply to any "extra" change order work you elect to or get called to do on a T&M basis.

So summarizing what I just said...you are essentially working with a selling price equation that looks like this:

(Estimated # of Billable Hrs x Loaded Labor Rate) + (Material Costs x NetProfit_Markup) +(SubContractor Costs x NetProfit_Markup) = Selling Price.


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## Jerrald Hayes (Apr 24, 2006)

rbsremodeling said:


> I say this with out any malice. *Order Michael Stones book: Mark up and profit. * He also has a CD that you can input the numbers and give you different scenarios....


Malice? I'm not really sure just what you meant by that. Were you aware of the problems the problems with the Uniform Percentage model that Gerstel illustrated in his book and that I've written about?


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## Jerrald Hayes (Apr 24, 2006)

MALCO.New.York said:


> Base your overhead on 2000 hours then divide and apply to a particular job. DO NOT forget to "Add A Little Extra" to each job.


While I think your general thinking and intent are correct for a one person company I think 2000 per person sounds a little bit high. The best companies that run like tops that I've seen generally have employees that generate around 1600-1700 billable hours and it is not all uncommon to see service companies like plumbers, electricians, and mechanical contractors at around 1200. Their even lower billable hour ratio is often due to their having their employees starting and ending up at the shop each day which are typically non-billable hours. Electrical plumbing and mechanical contractors working large projects where they can have their employees start out and end their day on the worksite each day and clock in eight hours there typically have ratios more in line the carpentry contractors that can generate around 1600-1700 billable hours.


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## Jerrald Hayes (Apr 24, 2006)

Burby said:


> Is this a math test??


I'm wondering that too but I never seen any kind of correlation between material costs and job size as I seem to think you might be alluding too when you wrote:


Burby said:


> 20 years ago if materials were $10,000.00 the job would be close to $20,000. Today if materials are $10,000 bid is typically between 30 to 60k


 or am I missing your point that you are trying to make about something else?


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## rbsremodeling (Nov 12, 2007)

Jerrald Hayes said:


> Malice? I'm not really sure just what you meant by that. Were you aware of the problems the problems with the Uniform Percentage model that Gerstel illustrated in his book and that I've written about?



Yes and I think you and Mr Gerstel make good points. 

I think Of Michael Stones book and Mark up software basic construction math and a foundation for guys to start the process of thinking .

His method is simple and easy to implement for most. I have always thought small steps for most were best.

Malice: desire to cause injury, pain or distress.


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## rbsremodeling (Nov 12, 2007)

Jerrald Hayes said:


> While I think your general thinking and intent are correct for a one person company I think 2000 per person sounds a little bit high. The best companies that run like tops that I've seen generally have employees that generate around 1600-1700 billable hours and it is not all uncommon to see service companies like plumbers, electricians, and mechanical contractors at around 1200. Their even lower billable hour ratio is often due to their having their employees starting and ending up at the shop each day which are typically non-billable hours. Electrical plumbing and mechanical contractors working large projects where they can have their employees start out and end their day on the worksite each day and clock in eight hours there typically have ratios more in line the carpentry contractors that can generate around 1600-1700 billable hours.


Agreed, while I factor 2000 billable hours of work performed by my guys, 1500-1600 are job site tasks the other 400-500 are considered Jobsite management costs


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## MattCoops (Apr 7, 2006)

buildpinnacle said:


> BTW, how much would you charge to replace an interior door unit if the HO is supplying the hinges and the hardware, but you are supplying the pre-hung unit. She wants these special hinges so you have to swap the originals out, she wants to save the casing, but remove the paint and stain it. The original opening is roughed for a 2'8 door, but she wants this one to be 3'0. Do I have to allow for drywall? Is my O/H different if the work is to be done on a weekend? What if we work when it is snowing since it will take longer to get there and my guys will be cold. Do I charge her for the extra time to bundle up and unbundle when we get indoors? Man, I'm gonna see if Starbucks is hiring.


:thumbup: I vote this as best post for 2008. :thumbsup:


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## Jerrald Hayes (Apr 24, 2006)

rbsremodeling said:


> Yes and I think you and Mr Gerstel make good points.
> 
> I think Of Michael Stones book and Mark up software basic construction math and a foundation for guys to start the process of thinking .
> 
> His method is simple and easy to implement for most. I have always thought small steps for most were best.


Thanks for your very quick reply RBS but a Uniform Percentage Markup isn't any simpler or easier than a Capacity Based one and I can in fact argue that it is a lot more complicated to work with in real practice.

Case in point (and this is only the first test case) lets say based on your 2007 costs which were 28% your own company's labor, 42% materials and 30% subcontractors you have figured out the Uniform Percentage Markup you need to use for your company is 1.55 (or any other hypothetical figure you want it to be for that matter). 

Now the fellow that owns the lumber yard you get all you material from tells you he wants to hire you and your crew to supervise construction and perform the carpentry for him a new home he's building for himself only since he owns a lumber yard he is going to provide all the materials for the project. How do you go about adjusting your markup to make up for the 42% gross profit shortfall you will have not supplying the materials while you are working on that project?


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## DavidC (Feb 16, 2008)

As I've stated before, M. Stone's book got us pointed in the right direction and greatly improved our bottom line. Later, after reading Jerralds method, we did duo estimates for awhile using both methods.

The end results were nearly the same when we supplied all materials. The bottom line cost to the client was very close. In instances where the customer supplied materials we took a hit with the volume based method. The capacity based method negated the effect.

We currently load the labor rate for all overhead recoupment, marking up both labor and materials for our profit goals. Thank you for that Jerrald Hayes.

Good Luck
Dave


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## ruskent (Jun 20, 2005)

I was taught that it is bad to use material markup to recover overhead.


I recover all overhead through my hourly labor rate.


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## rbsremodeling (Nov 12, 2007)

DavidC said:


> As I've stated before, M. Stone's book got us pointed in the right direction and greatly improved our bottom line. Later, after reading Jerralds method, we did duo estimates for awhile using both methods.
> 
> The end results were nearly the same when we supplied all materials. The bottom line cost to the client was very close. In instances where the customer supplied materials we took a hit with the volume based method. The capacity based method negated the effect.
> 
> ...


This is where material allowances and a bit of thinking it through helps.

When I estimate a job and lets sat its 50K priced out

IF materials are lets say 15k cost. IF the homeowner wants to supply materials or anything else the cost of that item is subtracted not the price/overhead.

So my overhead is still included in the contract even for the items supplied by the homeowner.

With me they save absolutely nothing by purchasing material on their own in fact it always cost them more time, money and usually some aggravation. If they buy it it is their responsibility for it and I charge to correct problems that arise if it is wrong. Even if it is just going and swapping it out for the right part or picking it up for them.


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## rbsremodeling (Nov 12, 2007)

Jerrald Hayes said:


> Thanks for your very quick reply RBS but a Uniform Percentage Markup isn't any simpler or easier than a Capacity Based one and I can in fact argue that it is a lot more complicated to work with in real practice.
> 
> Case in point (and this is only the first test case) lets say based on your 2007 costs which were 28% your own company's labor, 42% materials and 30% subcontractors you have figured out the Uniform Percentage Markup you need to use for your company is 1.55 (or any other hypothetical figure you want it to be for that matter).
> 
> Now the fellow that owns the lumber yard you get all you material from tells you he wants to hire you and your crew to supervise construction and perform the carpentry for him a new home he's building for himself only since he owns a lumber yard he is going to provide all the materials for the project. How do you go about adjusting your markup to make up for the 42% gross profit shortfall you will have not supplying the materials while you are working on that project?


By removing the *cost* of the items from my estimate and not my *overhead/mark up* on that item, the markup still remains in the estimate.

That is why you don't give anyone estimates with breakdowns but allowances for items that need to be decided on or picked out.

I always price out full labor,material and sub pricing in estimates if something is removed it is the *cost *of the item the *overhead* still remains in the fee. overhead and profit does not change because materials are remove or supplied


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## ProWallGuy (Oct 17, 2003)

Excellent thread! I just rated it 5 stars. :clap:


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## DavidC (Feb 16, 2008)

Just posting because I saw my post count and wanted to change it.

Good Luck
Dave


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## Jerrald Hayes (Apr 24, 2006)

rbsremodeling said:


> By removing the *cost* of the items from my estimate and not my *overhead/mark up* on that item the markup still remains in the estimate....
> 
> ...I always price out full labor,material sub in estimates if something is removed it is the *cost *of the item the *overhead* still remains in the fee. overhead and profit does not change because materials are remove or supplied


I've got a couple of questions for you RBS (that's a euphemism for "challenges" or "things we can debate") but I am headed out the door to the Apple store and then off to a Cold Fusion users group meeting. But I will leave you with one question that I think is apropos given that I'll be at a programmers meeting tonight. I can't think of a computer estimating program or even a simple spreadsheet that easily and conveniently allows you to do what you've just described. From a programers perspective (I develop applications in FileMaker, Cold Fusion, and Excel/Numbers) it can be done but it's jumping through hoops to support a bad methodology. In other words why do it to support a financially flawed method....And for the life of me I can't think of any program that accommodates that technique you've just described. How are you doing that?



rbsremodeling said:


> That is why you don't give anyone estimates with breakdowns but allowances for items that need to be decided on or picked out.


Well in my contracting company we will give breakdowns of costs to our prospective clients but we never breakout our overhead and profit. We've always done as William Asdal recommends in his excellent book *Defensive Estimating: Protecting Your Profit*....we "Use Retail Pricing at Every Line". Breaking out overhead & profit doesn't help clients make the decisions they need to make in planning their projects. It only confuses and obfuscates the issues. When you go into an Apple store you don't get a breakdown on the materials, labor,overhead and profit that Apple calculates into the price of their products. You look at the machine and decide one way or another whether a 24: iMac is worth $1,799.

I'll talk with you again tomorrow I hope.


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## rbsremodeling (Nov 12, 2007)

Jerrald

I will try to get a couple of screen shots from my software to show how it is done. 

I love debates so I do not mind the questions or giving answers. I have an extreme thirst for knowledge and love good arguements/conversations, so I look forward to it and I hope it turns into a learning experience for me and others as well.


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## orson (Nov 23, 2007)

Where are you guys getting 2000 hours?

The following holidays put us at 3 days: labor day, independance day, and memorial day. 

Now you have potential holidays: Christmas, New Year's Day, Thanksgiving, Easter

Add to that the first one or two days of hunting season.

Now tack on a minimum 1 week's vacation.

Don't your guys ever get sick or have a dentist's appointment? 

I personaly think using 2000 hours is unrealistic.


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## rbsremodeling (Nov 12, 2007)

orson said:


> Where are you guys getting 2000 hours?
> 
> The following holidays put us at 3 days: labor day, independance day, and memorial day.
> 
> ...



40 hours x 50 weeks == It is unrealistic. At least production wise it is impossible. My guys work about 1400-1600 actual production hours and I a lot 400-500 hours as management time.

For me that amounts to about 120k in management fees for *them*. That is off the top of my head so it may be more or less

Who pays for the vacation time, Christmas, thanksgiving time etc????????????


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## DavidC (Feb 16, 2008)

RB, Checking to see if I understand what your saying. We currently use a process of including certain items in a proposal that the customer will select. They are listed as allowance items and we try to keep the allowances higher than the average purchase we see. Many times the customer will just pick it up and bring it home. In this case we simply deduct the amount of the total allowance. If we pay for it then we credit the customer for selections under the allowance, invoice for amounts over. Either way our markup is preserved. Potentially we could suffer a slight hit for purchases over allowances, but hasn't been an issue for us yet.

Are we on the same page or do I need clarification?

Good Luck
Dave


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## rbsremodeling (Nov 12, 2007)

DavidC said:


> RB, Checking to see if I understand what your saying. We currently use a process of including certain items in a proposal that the customer will select. They are listed as allowance items and we try to keep the allowances higher than the average purchase we see. Many times the customer will just pick it up and bring it home. In this case we simply deduct the amount of the total allowance. If we pay for it then we credit the customer for selections under the allowance, invoice for amounts over. Either way our markup is preserved. Potentially we could suffer a slight hit for purchases over allowances, but hasn't been an issue for us yet.
> 
> Are we on the same page or do I need clarification?
> 
> ...


100%

If the purchase is over the allowance which rarely happens for me its ok my mark up is still met.

If the item requires more labor or additional material to install that item, they will be charged for it so my allowance specs are included and detailed enough so that if I spec a certain stove no one brings home a dual fuel Viking to be installed at the same fee as a GE Range.

But I think we are on the same page


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## orson (Nov 23, 2007)

I'm in complete agreement with Rory and basically use the same method. I base my markup on the complete scope of work. If the customer supplies something I remove cost only leaving the same amount of overhead and profit dollars.

overhead and profit only go down if the scope of work goes down.


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## SNC (Dec 2, 2008)

buildpinnacle said:


> Someone could make millions starting a 'school' for contractors new and old. The very first thing that should be taught is properly estimating a job. Could've saved me tons of lost money


 I have to agree 1000% I can frame dam near anything you can draw, but I'' be damed if I can tell you (ahead of time) how long it will take.:jester:


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## Winchester (Jun 29, 2008)

Want to hear a funny story? No, well too bad!

I was billing out my man hours at pretty much the average of 2x wages for all employees, and using this for overhead & profit which was working out perfectly.

Well, I didn't know my overhead or how to accurately calculate down to the hour until reading these threads lately.

I just worked everything out in excel including future expenses I don't really have much of yet, like marketing, and a set salary for myself.

After adding everything in excel and using 1400 manhours I came to exactly within 5 cents of my current arbitrary man-hour rate! :clap:

*So basically, if I want to achieve my future marketing budgets, fixed salary for myself, etc. I'm losing $0.05 per hour!

*(the only redeeming point is that I used 1400 hours instead of 1600-1700 because I like to play things safe, and be able to take vacations)


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## DavidC (Feb 16, 2008)

rbsremodeling said:


> 100%
> 
> If the purchase is over the allowance which rarely happens for me its ok my mark up is still met.
> 
> ...


The reason I asked is because I don't see that scenario as a function of estimating software. I may be off base on this since we haven't integrated our estimating, proposals and bookkeeping. 

I'll pay attention while you and Jerrald work it out.

Good Luck
Dave


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## rbsremodeling (Nov 12, 2007)

DavidC said:


> The reason I asked is because I don't see that scenario as a function of estimating software. I may be off base on this since we haven't integrated our estimating, proposals and bookkeeping.
> 
> I'll pay attention while you and Jerrald work it out.
> 
> ...



Are you using software for estimating right Now David?? Take a look and down load the Demo of Smart contractor 

http://www.smartcontractor.com/

This is not the software I use. It was on my list, but chose another one for reasons that benefited my company. But thought it was an a very good product.


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## Jerrald Hayes (Apr 24, 2006)

RBS are you still going to get back to me with and explanation as to just how to apply your estimating technique of


rbsremodeling said:


> ... removing the *cost* of the items from my estimate and not my *overhead/mark up* on that item, the markup still remains in the estimate.


 ...works in the software that you use?

I took a little look at the software you were suggesting DavidC take a look at and I didn't think it could be easily executed with that program or with any other estimating programs that I am familiar with. 

The next question in line I guess would be given all the financial problems inherent in using a Uniform Percentage Markup why not just use the Capacity Based Markup since it works all the time?


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## rbsremodeling (Nov 12, 2007)

Jerrald

I will, my intellectual post come in spurts. I just have to be in the mood to think. 

But I do think this is a very important post. I will try my best to get the mind working and the info posted.


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## Winchester (Jun 29, 2008)

Jerrald Hayes said:


> RBS are you still going to get back to me with and explanation as to just how to apply your estimating technique of ...works in the software that you use?
> 
> I took a little look at the software you were suggesting DavidC take a look at and I didn't think it could be easily executed with that program or with any other estimating programs that I am familiar with.
> 
> The next question in line I guess would be given all the financial problems inherent in using a Uniform Percentage Markup why not just use the Capacity Based Markup since it works all the time?


Wouldn't be easier to just do it on paper?
If the software does the estimate for you, and you have the numbers (cost, mark-up, etc.) Then couldn't you just subtract the cost yourself (on paper), and keep the same numbers already generated by the program. Just subtract the cost of whatever particular item was being removed from the total?

I hope that makes sense. Also, I don't use software for estimating at the moment.


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## RayContracting (Oct 25, 2008)

Here is a post that I did about a month and a half ago, and since I wanted to add my 2 cents on how I have always gone about estimating, I am re-posting it again. I would love to get your feedback on my method:

"In order for any contracting company to complete Accurate Estimating, they _must_ 1st have a decent accounting software or system already in use within their company. Without this necessary tool, attempting to complete precise proposals is simply a shot in the dark, and I will explain why.
There are a few basic business accounting concepts that we must 1st define:
*Sales* -This is the easiest one and is simply the combined invoice totals of all the Sales you complete, or sell.
*Job Costs* - (aka Cost Of Goods Sold- COGS) - This is the amount of money that is paid out (cost) for completing a Job, either directly or indirectly. This is often a highly debated definition, and you may see a wide variety of uses on COGS. For contracting purposes it is extremely important to separate these costs from all of the other costs associated from running a business. Nearly all software includes this COGS as a separate Account Type. Another way to think of a COGS is any labor, direct or indirect, or material part used and/or purchased for job. Here are some examples of what I feel _are_ Cost Of Goods Sold:


Field/ Technician Labor -(Wages, Salaries, Commissions, Bonuses or Reimbursed Expenses) paid to the individuals completing the work for the customers.
Subcontractors -Any money paid to a vendor or subcontractor completing work for you at your expense, for an outside or customer job.
Materials, Parts or Items Purchased or Used for a job- While this may seem obvious there are a few items that often get overlooked. If you keep an inventory, these items are _only_ expensed out when pulled from the inventory and used on a job. If inventory is not kept, any material purchased for a job, whether it is used on the job or not, must be expensed as a COGS as well. COGS must also include any Equipment Rented, or Tools Purchased for a specific Job
Insurance - This is an often overlooked COGS, however any insurance paid for, or due to the Field Technicians Labor (ex. Workers Compensation, Non-owned Auto Liability Ins. for field staff vehicles should be considered a COGS, because it is directly related to specific jobs it is being used for.)
Paid Time Off for Field Staff/ Technicians- This is another overlooked expense, but it is a big one. Any paid time off (ex. Holidays, Vacations, or Sick Leave) paid to these particular employees should also be considered a COGS.
Employer Paid Taxes for Field Staff/ Technicians- While sometimes difficult to separate from the other staff, this is also an important cost that is directly related to jobs because is in direct proportion to the labor paid to those technicians who are completing the work.
Benefits Paid to Field Staff/ Technicians -This, as well, must be considered a COGS because this is a direct cost to those individuals actually doing the work. Benefits could include company paid 401K contributions, fuel reimbursements, radio/ phone costs, company paid Health Insurance Premiums etc.)
 *Overhead* -also known as Fixed Expenses, can be defined as any expense that company may have regardless of the quantity or size of the jobs they do., how I define it, is those fixed costs to a business weather they do one or 1000 jobs a year. "_Overhead—advertising, rent, insurance, utilities, phone, owner’s salary, etc_" as Brian's earlier post accurately described it. I would also like to add office staff salaries and all of the costs associated with them, as well as any other office or warehouse location expenses.

So know that we are all on the same page, how do we turn this information into an Accurate Estimate? First we have to determine what percentage of our total Cost of Goods Sold as compared to our Overhead.
Using your accounting software, you should be able to run a basic Profit and Loss statement. If you run this report for the Last Year-To-Date, (last 12 months) it should give you at least your Total Sales, Total Cost of Goods Sold and your total Overhead. Lets assume our total COGS is $300,000 for the prior 12 months and our overhead is $100,000. We know know that to break even we must have done a minimum of $400,000 in total Sales. Another way of putting that is that if our COGS is $300,000, we need to add 33% above, or _on top of_, that amount to break even ($100,000 / $300,000 = .333) This formula would also work if you overhead was $600,000, then your percentage would be 200%. We can call this our _*Minimum Markup Percentage*._
Having this information for future bidding is critical, however we have just used the #'s from the last 12 months. We want to take this information we have but use it to bid jobs for the next 12 months. So how do we do this?
If we expect our Sales to rise by 10% in the next 12 months, it would be safe to assume that our COGS would also rise 10%, so we could _add_ 10% onto the last 12 months of COGS. Using our example that would make our estimated COGS $330,000. Now lets take our fixed expenses. Do we expect any raise or decline in this area. Is our rent going up? Will we be hiring another office staff? Do we plan on doing any downsizing? By answering these questions we can estimate any changes in the Overhead for the next 12 months as well. We now plug in our new numbers into our formula to update our Minimum Markup Percentage (Overhead / COGS = Minimum Markup Percentage) We can use this Updated Percentage as our Minimum Markup Percentage for all future jobs within the next years. (This same formula can be done for one, three, and six month intervals if your totals are available in your accounting reports)
Knowing this Minimum Markup Percentageis critical for any contractor to to be able to Estimate Jobs Profitably. Any percentage above this #, to include profit, is your *Markup Percentage*
When Bidding jobs it will be critical to know the Actual Costs of that Job during the bidding process.
Many contractors understand Direct Costs when it comes to materials purchased and/or used on a job, as well as subcontractor expenses, and equipment rentals etc., however where contractors often fall short is in estimating the labor costs involved in a job. When a contractor has employees either Salaried or Hourly, they will often assume that if they pay the employee $20.00 an hour, their labor costs for a 10 hour job would be $200.00. This is dead wrong. The Actual Hourly Cost _must_ take into consideration _all_ of the other, direct costs of that employee, to the employer to determine the Actual Hourly Cost. These direct costs can include:
a.Employer Paid Labor Taxes
b.Workers Compensation Costs
c.Paid Days Off (Holidays, Vacation, Sick)
d.All other Employer Paid Benefits (ex. 401k, Radio/ Phone Reimbursements, Uniform Costs, Fuel Reimbursements, Vehicle Costs/ Reimbursements etc)
Once all of these costs are determined, they can then be calculated into an Actual Hourly Cost for that employee. For example, if an employee is paid $20.00 an hour and all of the above costs are taken into consideration, an employer’s Actual Hourly Cost for that employee may be a lot closer to _$30.00 per hour!_ If these employees are paid for driving time to and from the job, this time must also be added to the total time a technician or team spends on a job. Then, and only then, can an estimator know their true labor costs on a job.
Now that we can accurately determine the actual labor costs on a job, we must add in all of the other Estimated costs related to the job to determine our *Total Job Costs*. We then add in our _Markup Percentage _to determine the Total Estimate or Proposal Amount. We can then determine the Gross Profit (Estimate Total – Total Job Costs = Gross Profit). Many contractors will also take into consideration Estimators’ or Sales Rep. commissions which may be based on this Gross Job Profit to determine their commissions. One common way in determining the Net Profit is: Gross Job profit – Commissions Paid = Net Profit. 
Well I hope I did not confuse you any more and sorry for the long post, but I felt it was worth explaining. That’s my 2 cents worth. I would love to hear other opinions and feedback.
Ray"


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## Jerrald Hayes (Apr 24, 2006)

RayContracting said:


> Here is a post that I did about a month and a half ago, and since I wanted to add my 2 cents on how I have always gone about estimating, I am re-posting it again. I would love to get your feedback on my method...


Hello Ray, thanks for posting that again here in this discussion. 

I have a couple of comments.

The markup methodology that you've described that you use is the same Uniform Percentage Markup (aka Total Volume Based Markup and Across-the-Board Markup) that I first learned from reading Walt Stoeppelwerth's book Professional Remodeling Management and attending his seminars back in the late 80's. It's the same method that Michael Stone advocates in his book and that I have been criticizing here.

The forum rules here don't allow me to link directly to any articles in my blog but if you Google *One of the Potential Problems in Using a Traditional Volume Based Markup* and *Comparing Markup Methodologies In Real Some World Pricing Scenarios* you will find that there are some real big dangerous flaws in using that methodology and as I mentioned in *my post #42* here author/builder David Gerstels also explains the problem in Chapter 5 Estimating and Bidding on pgs 167 through 168 and in two sidebar blocks on pg. 167 of his book * Running a Successful Construction Company* and you can even read the excerpt online via *Google Books*.

I think I would also add that in the paragraph where you describe "Cost of Goods Sold" you say "_This is the amount of money that is paid out (cost) for completing a Job, either directly or indirectly._" and I would question your use of the phrase "_or indirectly_" in that definition. 

All the definitions I know and use regarding "Cost of Goods Sold" talk about COGS as being just the "direct costs".



> COGS is the costs that go into creating the products that a company sells; therefore, the only costs included in the measure are those that are directly tied to the production of the products.


and



> Cost of goods sold, COGS, or "cost of sales", includes the direct costs attributable to the production of the goods sold by a company. This amount includes the materials cost used in creating the goods along with the direct labor costs used to produce the good. It excludes indirect expenses such as distribution costs and sales force costs.


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## rbsremodeling (Nov 12, 2007)

Jerrald

I re read you question your are right the software does not remove the cost without effecting the price.

It gives me the break downs for everything and if I need to remove item(s) I would have to manually adjust the pricing.


I do not know enough to give an opinion on capacity base markups. 

I visited your site years ago and it has been brought up in discussions with other remodelers over the years. 

In fact I mention it in one of my earlier post. I will have to do some homework and see what are the benefits of using a capacity based market system.

I learned using Walt Stoeppelwerth's method's as well. So that might be why I am biased. 

I will look into the capacity base system some more so this discussion is not one sided.


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## Jerrald Hayes (Apr 24, 2006)

RBS worked with Walt's method (the Uniform Percentage Markup Method), and I actually learned it straight from him back in 1985 and up until around 1987 when I was blind sided and felled by "the problem within it".

I first learned about "Markup" in seminar I took taught by Walt and bought his books Professional Remodeling Management and I learned to use what can be variously described as Traditional Estimated Total Volume Based Markup method or Uniform Percentage Markup Method or Across-the-Board Markup and the forumula look like this:

*Job Price = (Labor Cost x UPM_Markup) + (Matls Cost x UPM_Markup) + (Sub Cost x UPM_Markup)* 
or  
*Job Price = (Labor Cost + Matls Cost + Sub Cost) x UPM_Markup*​
I can't tell you how much of an improvement that made in running my business vs. what was my previous method at that time which was a mix of "charging what I think other contractors are charging" and "pure guesstimates as to what to charge". All of a sudden I discovered I was really running a business that was making money vs. a "sometimes I make money, sometimes I don't scenario". I had a real pricing methodology that was actually working out.

I think I ran along using that method for for two or three years and built my business up to twelve guys building decks and small additions for homeowners when an opportunity for new line of work came along that I was very interested in doing. I was invited to do all the interior and exterior finish work for a design/build architect/builder on a series of homes and remodeling projects that represented anywhere form six months to maybe three years worth of work so I jumped at the opportunity. Aside from the attractions of getting to do "architectural woodwork" on luxury homes I was attracted to the work because I wouldn't have the headache of ordering and supplying the materials for the projects or coordinate the work being done by subs. It seemed like a no-brainer to me. In fact I thought it seemed like a gold mine opportunity. What could be easier.

What I've written about as "the problem" in my blog article: One of the Potential Problems in Using a Traditional Volume Based Markup, while a fictional scenario was based on the true story of what happened to me back then.

We started working on those projects in August or September of 1987. I remember not thinking too much of the Black Monday Stock Market Crash when it hit in mid-October that fall until I started to find that payments on the work we were doing were now not as timely as they once were and things started to get tight . The architect/builder we were working for was getting paid slower by his clients (who were financing their projects off of the gains they had made in the stock market up until then) so we were in turn getting paid slower and I attributed the tightening in the cash flow to that that delay. I never even saw what was really happening.

Nowhere in what I had learned up until then was it written (and there wasn't much written on the topic at that time anyway) that if you are going to use a Traditional Estimated Total Volume Based Markup method you have to carefully look at monitor and maintain the same mix and/or ratio of Labor, Materials and Subs that you computed your markup on initially otherwise it wouldn't work and it would leave you short if one of those factors changed in the future. I still had the exact same Labor Costs as I always had (12 employees and I even added 4 more at one point) and my Overhead didn't change at all and in fact may have even gone down in that time period because I stopped renting a shop and storage place for materials that I had since I no longer needed it. What changed for me was I no longer had billings for Materials and Subs generating Gross Profit that would contribute cash towards the Overhead I still had.

I don't remember for sure what the ratio of Labor, Materials and Sub Costs that I had back then was but I think it was probably close to Labor 50% to Materials 30% to Subs 20%. Take the Materials and Sub Costs out of the equation (they total 50%) and your only covering half of your overhead! That was what was really killing me not the slow down in the payments but I never saw it at the time.
And my accountant-bookeeper didn't tell me either. Maybe because her emphasis was on Financial Accounting as opposed to Cost Accounting she didn't see what was really going on. Her advice to me was to get paid by client in a timely fashion (which I wont ague against, that is always good advice) and to get more work which made no sense to me at all at the time and even less sense given what I know today. Get more work!?! Heck, we were working at our full capacity as it was. I even gave up or neglected supervising to bang the nails to help out and yet we were still not making any money. Or at least I thought we weren't making any money, as it turned out it wasn't that we weren't making any money it was that we were actually bleeding money!
To cut costs as work continued that following spring I fired the accountant-bookeeper. Or maybe she quit or just stopped working since I couldn't pay her anymore and I took over those chores. Beginning that summer I told my guys I couldn't make ends meet any more and that they should look for other jobs and phased them out. I guess still not wanting to give up and quit entirely the last day in July I took a seminar sponsored by New England Builder magazine (now known as JLC) called How to Survive and Prosper in the Contracting Market taught by Irv Chassen of PROOF Management Consultants. It was probably the "Survive" part of the seminar title that caught my attention.

A lot of if not most of everything that was covered in the seminar flew over my head at the time but the key message that tying overhead recovery to labor as opposed to tying it to all three volume components, Labor, Materials and Sub Costs would insulate and protect your company from any variances in Material and Sub Costs. A better more robust bullet proof way to calculate a Job Price:

*Job Price = (Labor_Cost x CBM_Markup) + (Matls_Cost) + (Sub_Cost )*

but taking into consideration that you still want to generate a Net Profit on the materials and subcontracting you are providing it really should look like this:

*Job Price = (Labor_Cost x CBM_Markup x NetProfitMarkup) + (Matls_Cost x NetProfitMarkup) + (Sub_Cost x NetProfitMarkup)*​

It's sometimes argued that you still have the variance in labor cost to contend with but that's not really all that true. Provided you are not hiring and firing employees (which to me indicates another management problem altogether) you pretty much stick with the crew of people that you have and they pretty much work a constant or relatively constant number of hours per week, per month, and per year so you costs for them will be relatively constant. Or at least you own labor is more predictably constant than what kind of costs you will generate for Materials and Subcontracting.

At the very least instead of having to estimate your company's expenses for the year in three separate areas for the purpose of tying them to overhead recovery you only need to estimate the cost or expense in one area; labor. That's also a lot simpler.

I don't necessarily think a Traditional Estimated Total Volume Based Markup method is intrinsically or inherently ALL bad or broken. I think my point is the traditional markup method is potentially and dangerously vulnerable. It's also not as scalable nor anywhere near as accurate as a Capacity Based Markup method but that is perhaps another discussion in and of itself.

One of the other advantages to using a Capacity Based Markup is with what you charge for materials in the eyes of your clients. Generally speaking the prices for materials are known quantities to the public or at least readily attainable information. Using Traditional Estimated Total Volume Based Markup when you "sell" that door to your client you have to tack on a markup typically on average of maybe 50%. So a door that cost a $1000 dollars you have to "sell" to your client for $1500. The client then sees that door in a Home Depot flyer and wonders and argues with you why you're gouging them for that 50%, an extra $500! Whereas if your using a Capacity/PROOF/Indexed/Labor Allocated markup your selling them that door at cost or with maybe an 8% to 12% markup for Net Profit which is a lot more justifiable. In fact if you bought the door at a discount that 8% to 12% may only bring the door to its MSRP (Manufacturers Suggested Retail Price).

Where this really comes in to play and using a Capacity Based Markup system becomes an advantage is when you are working on a very custom job where you have to break out materials as different options or price them as allowances. If the client chooses the less expensive options your not penalized or hurt and if they choose the more expensive options you still make a nice Net Profit on the sale. Your overhead was recovered and paid for by the labor you provided on the installation and not as part of the material sale.

Given the advantages of using a Capacity Based Markup and the potential financial risks in using a Uniform Percentage one I can imagine how contractor's can rationalize not using it.


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## hcarlos (May 8, 2008)

you all are very informative so what does he do there is no right answer huh?


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## Jerrald Hayes (Apr 24, 2006)

hcarlos said:


> you all are very informative so what does he do there is no right answer huh?


You mean what does the original posted T.D.G. do?

I think it's pretty clear.

There are basically three main divisions of pricing techniques contractors can use.

1. *A wing and prayer, charge what you think (guess) the market price is or what other contractors might charge. *

It's certainly not very scientific and it's not very professional nor business-like. And it's not at all systemic, meaning it's not something you can codify, explain and build into a company system that you can eventually train somebody else to do.

2. *A Uniform Percentage Markup* (also known as Total Volume Based Markup or an Across-the-Board Markup)

While using this technique for pricing you are at least using a business-like methodical system there is in it a serious structural flaw that can potentially expose the user to varying and potentially damaging financial results.

And 3. *A Capacity Based Markup* (also sometimes known as PROOF, Indexed, Differential, Schedule Based, Labor Allocated, or PILAO)

This technique gauges and links your overhead recovery on your company's available "capacity" for work I.e. the amount of billable labor hours you company has available for to generate "work product" in a given time period (year). As I've said before this is the preferred method described in David Gerstel's book * Running a Successful Construction Company* and Ellen Rohr's * How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love* and Irv Chasen's *How to Survive and Prosper in the Contracting Market* manual which unfortunately is no longer readily available.

It is a robust and scalable method which (unlike the Uniform Percentage Markup method) I have yet to find a model scenario in which it doesn't work.

In terms of finding the "right answer" I look at things this way:

A wing and prayer, charge what you think is right — Wrong answer.

Uniform Percentage Markup method — Okay, it better than nothing, but it's risky and inconsistent.

Capacity Based Markup method — Best Answer. Safe, secure and consistent.

That's my analysis. I could very well be wrong but someone is going to have to answer all the problems I've pointed out with the Uniform Percentage Across-the-Board method and present a pretty good well formed cased to convince me otherwise.


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## TBFGhost (Oct 9, 2008)

?
http://360difference.com/Shareware/PILAOExcel.cfm


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## orson (Nov 23, 2007)

Jerald,

Great posts, thank you for the in depth description!

I read Stone and Gerstel within a few weeks of each other and immediately recognized he was describing a much wiser system of markup, among other things.

I set about calculating the hourly rate I would need to use a capacity based markup. I also calculated a volume based markup.

The first several estimates I did both methods yielded estimates within a few percent of one another: obviously my mix of labor/materials/subs was falling within the range needed for this to happen.

Once I got a feel for this I started just applying my volume based markup to all costs, however, in my spread sheet I would have a small table of markups and the overhead at those different markups. I would loosley look at the amount of overhead versus how long I thought the job would run and double check my overhead dollars within that time frame to make sure it was enough.

I think one reason I'm hesitant to adopt the capacity method is the risk associated with using high end materials. When you use a capacity markup and mark materials and subs up 10% to preserve your net margins aren't you assuming extra risk when using a lot of high end materials without an appropriate amount of reward for your risk?


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## Jerrald Hayes (Apr 24, 2006)

TBFGhost said:


> ?
> http://360difference.com/Shareware/PILAOExcel.cfm


That's a Capacity Based Markup tool that I designed out of a discussion we had regarding PROOF (Capacity Based Markup) on JLC back in 2004 ( *PROOF Worksheets in Library*).

Here are some other tools out there that support the methodolgy too.

Brian Drucks has *YourCostCenter.com* whose site also has an excellent article by Irv Chasen (the fellow who taught me the method all those years ago) entitled *Science, not art, and certainly not guessing*.

And there is also Diane Gilson's *InfoPlusAccounting.com* which has an excellent article about developing “fully-loaded” labor rates entitled: *Increase Profits with Labor Burden Data and Employee Billing Rate Information*. She also has an Excel based product that integrates will work with QuickBooks to give you correctly loaded Billing rates for billing purposes in that program called *Qlean$tart™ Worksheet*.


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## Jerrald Hayes (Apr 24, 2006)

Hello Orson, 

Last night I wrote this reply to your comments regarding the possible increased of more expensive materials but checking in here this morning I can see I must have clicked the preview instead of the post button and it never made it online. Whoops....

Regarding....(the emphasis in mine and it is a very good question)



orson said:


> ....I think one reason I'm hesitant to adopt the capacity method is the risk associated with using high end materials. *When you use a capacity markup and mark materials and subs up 10% to preserve your net margins aren't you assuming extra risk when using a lot of high end materials without an appropriate amount of reward for your risk?*


What's the risk? How do you gauge what it is worth?

In my contracting businesses we had a job a couple of years ago where we had to move a pair of multi-million dollar paintings off a wall along with some other extremely valuable works of art before we would even begin to work in the next room over. I called my insurance agent and bought some just-in-case coverage for our moving those valuable items.

If materials or a procedure are particularly risky I think (and it's a recommendation I've also had reaffirmed reading Asdal's *Defensive Estimating: Protecting Your Profit*, what you do is estimate that risk on a line item basis and not hope that it's covered for by some over-arching global markup.

That said I think most of the increase in common risk associated with a client choosing let's say the $5000 door over the $2500 one that was specified in the original estimate I think is well covered by a Net Profit markup somewhere in the range of 8-16%. Keep in mind the General Liability insurance (risk protection) we buy on our business is just a fraction of our gross revenues and it also is there to help mitigate that risk we are talking about too. How much more protection do we need? And if you are let's say marking up materials 1.1 to earn a Net Profit on them of 10% you earn $250 on the $2500 door and $500 on the $5000 door (charging $2750 and $5500 respectively) so I am not so sure what the big deal is.

Still there are Uniform Percentage Across-the-Board markup advocates who don't buy into my rationalizations regarding the increased risk they might incur on more expensive material and insist that the heavier markup that Uniform Percentage Across-the-Board method places on materials covers for that contingency. It doesn't and it can't because that cash in that heavy markup is already earmarked for paying the company overhead so it's just not available as risk contingency funds. 

Estimate and plan for risk on a line item basis.

Unfortunately I think risk is often a very misunderstood and misapplied concept amongst many contractors.


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