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Oil prices are affecting everything, from transportation costs to commodities, and you may be tempted to alter your pricing to increase your backlog as a cushion against future uncertainty. Maintaining your sales revenue is like a game of basketball: most games are won by just a few points. A winning pricing strategy also is based on watching every point.
You know that you must generate enough work to cover the cost of doing the work itself and your overhead. Ideally, you include a reasonable profit in your price. You also know that slashing prices when work is scarce is not a solution to the problem, and it makes covering costs impossible.
Contribution margin and break-even level
Break-even calculations are more difficult for electrical contractors than for manufacturers because you don’t produce a measurable unit of output, such as a box of paper clips or a pickup truck. Forecasting overhead can be difficult, especially in growth cycles. To keep things simple, use the relationship between your overhead and direct job costs (labor, materials, etc.) to establish your markup and break-even revenue.
For example, an electrical contractor has direct costs of $2,338,280 and an overhead of $362,880. We would divide the overhead by the direct costs (362,880 ÷ 2,338,280) and get .1552. In other words, the overhead is equal to 15.52 percent of the direct costs for the year. Adding 1 to that percentage and multiplying that total (1.1552) times direct costs (1.1552 x 2,338,280) produces a break-even sales revenue of $2,701,181.
The markup of 15.52 percent determines the contribution margin, the portion of each dollar of sales that contributes to covering part of the overhead. Using the formula % Markup ÷ (% Markup + 100), the contribution margin would be 15.52 ÷ 115.52 = .1343.
This means that 13.43 percent of every sales dollar is available to cover part of the overhead, and the remainder would go to pay direct costs.
Break-even sales revenue can then be verified by dividing the overhead by the contribution margin (362,880 ÷ .1343 = 2,701,175). The total varies slightly from the original $2,701,181 because we rounded the number of digits in the original 15.52 percent.
Let’s imagine this is your company. Competition is fierce, and you decide to slash prices and use a 5-percent markup instead of 15.52 percent. The new contribution margin is only 4.76 cents per dollar of sales revenue (5 ÷ 105 = .0476).
Now, calculate the new break-even point (Overhead ÷ Contribution Margin) to see how much of a revenue increase you will need: $362,880 ÷ .0476 = $7,623,529.
Oops. You will need to increase sales by 182 percent to get the extra $4,992,369 and break even. It’s not likely that you will be able to estimate, win and actually perform that much more work without raising overhead and digging the hole even deeper.
So, you are clearly aware that slashing prices doesn’t work, even as a short-term strategy.
Price slashing is like having a clear shot at the basket, but tossing the ball out of bounds instead. It’s obvious you are throwing the game. Why not shave a few points instead? Probably no one will notice, and if the team wins, no one gets hurt except the guys in Vegas, right?
What if we just use 15 percent instead of 15.52 percent as our markup? First, let’s see how this affects the contribution margin: % Markup ÷ (% Markup + 100), or 15 ÷ 115 = .1304.
In other words, every dollar in sales “contributes” 13.04 cents to overhead, so what is our break-even sales revenue? Overhead ÷ Contribution %, or $362,880 ÷ .1304 = $2,782,822.
This is much better, since we only need to increase sales by about 3 percent (roughly $82,600) in order to break even. This is a great short-term fix, but it is a slippery slope for several reasons. First, once you lower your prices, repeat customers usually resist when you try to raise them again. Second, there is a temptation to continue to shave the margin, and before you know it, you have eroded any profit and begun to lose money. Then, you try to cut overhead, and employees feel pressured to work harder. When you try to improve efficiency, your already nervous staff and craftspeople may actually make more errors, and pretty soon you are out of business.
So, make the difficult decision up front. Price your work so that you break even and make a profit. If you don’t get enough work at your price, you’re still out of business, but you have avoided chronic pain and suffering. It is far more likely, however, that being aware of the consequences of pricing strategies will make you more vigilant about other aspects of your business, and that is your best ally in the competitive game of electrical construction.
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at [email protected].