Are Poor Pricing Methods Destroying Your Bottom Line?
authors Dave Yoho
In a recent article, I stated that a well-run specialty home improvement company, which sells a single product line such as replacement windows, roofing, siding, or a combination of these or similar products, should target to earn no less than 10 percent pretax net profit.
A general remodeling company should plan to earn no less than 5 percent to 6 percent pretax net profit.
Now examine Chart A (to the right), which breaks down how to analyze profitability using your operating statement, also known as your P&L.
Despite what you may have heard, or believe, a proposal estimate and contract price has to be figured based on the individual circumstances of your specific business. Most contractors start in the right place—with the cost of labor and material necessary to produce the finished job—but many soon lose their way.
Standard formulas, such as multiplying your direct costs by 1.5 or even doubling your labor and material, may not be a valid formula for your company. And it’s too late once you’ve sold and installed the work to find out that you have made little or no profit on a contract.
Pricing formulas must be based on actual and specific costs within your particular business. You need to know (not guess) what your overhead costs actually are.
Start by separating your sales and marketing costs from your overhead. Every ad, promo, jobsite sign, Yellow Page cost, display piece, home show participation and similar is a marketing cost.
In the case of very small companies, you have a sales cost even if you do all the selling. Not to allocate something for your preparation, prospect visits, sales follow-up, and phone time is to deny your value in this part of the process. At the very least, allocate the percentage that you would or did pay your salesperson—or what companies similar to yours pay their salespeople.
Once you have these costs separated, factor them against your total sales to achieve a percentage for each. Then project the net profit that you desire.
A Modern (Factual) Pricing Formula
(Percentages supplied are for example only.)
(G & A) Overhead 18%
Net Profit 10%
(Accountants often classify these under gross margins.)
The total percentage above, 48 percent, when subtracted from a 100 percent selling price, represents all other costs plus 10 percent profit allocation, other than labor and material often called direct costs or cost of goods sold.
This is a basic formula. It may require modification depending on the size and style of the project. Major remodeling jobs, smaller remodeling jobs and purely specialty contracts—such as windows or siding—all require several additional steps. However, nothing changes the fact that if these classifications listed above were to total 48 percent, the cost of labor and material to complete the job cannot exceed 52 percent of the selling price or you are eating into your profit.
Most contractors don’t get the price that they are entitled to, and it’s not because the finished product isn’t worth the money. The problem often lies in the inability to sell the value when presenting to their prospects.
At this point, you are able to assess profitability on each contract sold prior to starting the job. It’s pretty simple. On any job sold (if your percentages match the cited example) and the cost of your labor and material exceeds 52 percent, you are sacrificing a portion of your profit.
Such circumstances may require an adjustment to the commission on this job (contract) prior to accepting it. This may also be true of a completed job exceeding 52 percent based on additional promises to the customer of mismeasures occurring.
Each of the categories, such as a) fully loaded marketing costs, b) fully loaded sales costs [commissions paid to salespeople, project managers, sales managers, etc.], c) general and administrative costs and d) allocation for profitability, are listed in your operating statement. Any percentage increase in this account should appear on your internal (prior to the year-end) operating statement.
If you analyze your actual revenue (installed contracts) against what you are spending to acquire and install your work, this can and will enable you to examine whether your collective installed contracts were or were not profitable to the degree you intended with your pricing plan.
By further explanation, the operating (P&L) statement reports a company’s revenues and expenses over a period of time. If revenues exceed expenses, the company has a net profit. If not, the company has a net loss. Revenues (installed sales) in the home improvement industry are defined as inflows, mostly resulting from the completion of contracts requiring the installation of products—a combination of goods and services.
Expenses are defined as outflows resulting from the purchase of goods, rendered services and attendant expenses to support the advertising, sale and installation of home improvement contracts.
Operating (P&L) statement accounts are temporary and reset at the beginning of a new period. For example, at the end of the year revenues are closed and the accounts are usually set back to zero.
The operating (P&L) statement accounts become part of the retained earnings. When all operating statement accounts are closed at the end of the period, the net addition to retained earnings will be the net income or net loss that resulted during the period. As the account title indicates, retained earnings are earnings that are kept and reinvested in the company.
As a reminder, in the home improvement business, the proper way to do a profitability analysis is:
- Gross Margin
- Operating Profit
- Pre-tax Profit
Adjustments such as owner(s) draws
Miscellaneous income and/or one-time charges or write-offs
Reserve or allowance for taxes and/or uncollectible receivables
- Net Profit
CAUTION: Profitable operations do not necessarily create positive cash flow. This comes from getting the proper price to begin with, then working within the projection of all expenses to effect a projected profitability. To make your company more efficient and profitable, start by examining your pricing methods then correcting them to ensure you are earning the profit to which you are entitled. QR
Dave Yoho (daveyoho.com) is president of the oldest and largest consulting group serving the home improvement industry. He is the producer of a recorded series entitled, “How To Run A Profitable (Or More Profitable) Home Improvement Business.” For more information on his business, call 703-591-2490 or e-mail him at email@example.com.