Whether Your Are Veternarian Running An Animal or a Lawn Mowing Contractor The Underlying Alegebra, Math, and Logic  Remains The Same.

To succeed in a service based business, you have to price your jobs to cover all labor, material and overhead expenses, and make a decent profit. The problem is knowing what markup to use. You don’t want to lose jobs because you charge too much, and you don’t want to work for free because you’ve charged too little. If you know how to correctly calculate markup, you can apply it to your job costs to find the right sales price for your work.

The mistake that many service businesses make is they apply a markup pricing forumla that looks like this:

(Labor Cost + Material Cost + SubContracting Costs) x Markup = Selling Price

The problem with that formual is while it may work some of the time or even most of that time there are scenarios where fails leaving you over-priced in which case you lose the project based on price or underpriced where you get the project but lose money performing it.

A more robust method that works under all scenarios is the an Activity/Capacity Based Markup Method   that uses a formula that looks like:

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

The Loaded Labor Rate is the trick. Instead of relying on a Total Volume Based Markup Method .  applied to Material and SubContractor Costs to help you cover your Overhead Costs all your Overhead Costs are recovered as a function of how much company time (your labor) the project consumes.

For many projects the Total Project Price for both the Capacity/Activity Based Markup and the Volume Based Markup will be the same. Where they start to diverge is when the ratios Labor to Marterials & SubContracting start to vary, For example a Volume Based Markup (or Margin Based Markup) with a project that has a High Relative Cost of Labor to Low Cost of Materials, and SubContracting you will be underpriced. And with a project with a Low Relative Cost of Labor to High Cost of Materials, and SubContracting you will be overpriced and probably not get the job. 

I hope that all service based small businesses understand that you have to markup your costs to cover your overhead costs of doing business and to generate a Net Profit return on the dollars and time you have invested in your business but not all business people understand how to develop and apply markup correctly and end up ‘leaving money on the table’ or even worse paying out of their own pockets to do the project or job.

Understanding The Different Types of Markup

In the building & remodeling contracting world which is where I cam from there are basically two types of markup methodology that contractors will use: a Total Volume Based Markup Method that places a markup to achieve a prescribed Gross Profit on the sum of all the Labor, Materials, SubContractor, and Equipment costs and an Activity/Capacity Based Markup  that places the responsibility of recovering overhead costs on the available production capacity (or labor) a company has.

I make no bones about it, I teach and work with contractors and other service businesses to help them implement and understand the more robust Activity/Capacity Based Markup  methodology because of the dangerous flaws in the Total Volume Based Markup Method . 

In the first chapter of his excellent book Pricing for Profitability: Activity-Based Pricing for Competitive Advantage  John L. Daly writes:

… Three things can happen when establishing prices, and two of them are bad.

1. Overprice and lose a sale that would have been profitable at a lower price.

2. Underprice and make and unprofitable sale

Only the third outcome is favorable:

3. Price appropriately and make the sale as well as a profit

Although this is an oversimplified view of a complex issue, many companies are burdened with pricing method that consistently give away profitable sales to competitors while undercutting those competitors on money-losing propositions. When these companies make a sale than actually produces a profit, it often seems to more by accident than intentional design.

Many companies believe falsely that they are competent at pricing. Many president of small companies will say, “Pricing is an art. I know that our pricing is good because I do it myself.” Pricing is not an art. However, a well-designed pricing model may be beautiful in the same way as a well-designed piece of machinery. Pricing is a science as much as the design of that machinery is a science. Knowledge is power in pricing. Although pricing for profitability allows considerable latitude for creativity in structuring a deal, pricing remains as much a science as marketing, cost accounting, business strategy, engineering, and economics—the disciplines that converge in product pricing. If the person responsible fir establishing price says, “Pricing is an art,” it is a good indication that he or she is missing much of the basic data necessary to make informed pricing decisions.

I work with contractors to help them understand Activity Based Costing  and the ‘Science of Pricing’, the mechanics and methods that return consistent and stable Net Profit returns.