Pricing for Profit, Part 2

Breaking even or breaking the bank?

Last month, we looked at the concepts of markup and margin, and the connection between profit and the efficiency of job site operations; the formula for calculating the point at which your business breaks even provides the starting point for computing the volume of work you need to cover a certain level of overhead and generate a target profit level. This knowledge can help you analyze the difficulty of recovering targeted profit levels if you decide to cut prices in a competitive market.

The point at which you break even is the revenue that covers the cost of doing the work itself, plus your overhead, without generating any profit. The cost of the work is, of course, the direct labor and materials used in job site operations. If a company has annual direct costs of \$2,338,280, with overhead of \$362,880, then the calculation (\$362,880 ÷ \$2,338,280) shows that overhead is 15.52 percent of direct cost. If we add the dollar amounts for overhead and direct costs (\$362,880 + \$2,338,280), we may think that we need sales revenue of \$2,701,160 to break even, but it is not that simple, because your break-even revenue is based on something called a contribution percentage.

Direct cost divided by the inverse of 15.52 percent is the markup you actually use to price your work (1 – .1552 = .8448), if you want to break even. So, if you are estimating a project with direct costs of \$100,000, the calculation is \$100,000 ÷ .8448, and your break even price is \$118,371. Now, if you want to achieve a profit of 10 percent on this project, you do the same thing (divide by 1 – .10, or .90), which means that you take the previous subtotal of \$118,371 and divide it by .90, to produce a final price estimate of \$131,523. This price should allow you earn a 10 percent profit, and cover your overhead related to the direct cost of that project.

In order to understand the meaning of these relationships, we need to revisit the concepts of markup and margin from last month’s column. If your direct costs are \$100,000, and your final price is \$131,523, then you would be using the following markup (to obtain that price):

Markup = Selling Price – Direct Costs

Direct Costs

\$131,523 – \$100,000 = .31523 or 31.52%

\$100,000

and margin (the amount of that price that covers overhead and generates profit).

Margin = Selling Price – Direct Costs

Selling Price

\$131,523 – \$100,000 = .2397 or 23.97%

\$131,523

Break-even calculations are related to the actual contribution that each dollar of sales revenue makes to overhead and profit coverage. That contribution is equal to % Markup ÷ (% Markup + 100). The concept is easier to understand for manufacturing operations. If you were making widgets, and each one cost \$.85 to make, with a selling price of \$1.00, then each widget would contribute \$.15 to overhead and profit coverage.

Markup = Selling Price – Direct Costs

Direct Costs

\$1.00 – \$.85 = .1765 or 17.65%

\$.85

Margin = Selling Price – Direct Costs

Selling Price

\$1.00 – \$.85 = .2397 or 23.97%

\$1.00

Contribution = Markup

Markup + 100

.1765 = .15 or 15%

1.1765

If your overhead was \$10,000, you would divide it by the contribution percentage to obtain the number of widgets you would need to produce to cover that overhead without generating a single dollar of profit (\$10,000 ÷ .15 = 66,667). Widget number 66,668 would generate \$.15 of profit (if your overhead did not increase), and so would each additional widget.

How does this relate to electrical contracting? You don’t manufacture a product, so you will probably have to calculate your contribution using labor hours. Of course, there are such things as economies of scale and productivity changes as well as the need to increase overhead periodically, so these calculations are not completely precise. The point is to have a reasonable approximation of how your profit relates to your costs and revenues.

Now, a word of caution. You know that slashing prices will put you out of business, but you may be tempted at times to shave prices just a bit to gain a competitive bidding advantage. Your markup of 15.52 percent provides a 13.4 percent contribution, so your break even revenue would be \$2,708,060.

Break Even = Overhead Costs

Contribution

What if you round off your markup from 15.52 percent to 15 percent? By shaving a mere half percent, you raise your break-even point by \$74,762 or an additional 2.75 percent. It doesn’t sound like much, but if you continue to shave your markup, your profit will erode over time.

Accurate calculations and predictions are not the only tools needed to reach your profit goals. Next month, we’ll look at how your management philosophy also affects your bottom line.     EC

NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached via e-mail at bigpeng@sbcglobal.net.