The True Cost of Running a...

An Introductory Guide

The True Cost of Running a Business

AppreciationPHCC—National Association and the PHCC Educational Foundation wish to thank PHCC of Texas for extending the rights to reprint this guide, extracted from the 2012-2013 PHCC Texas Plumbing Continuing Education textbook. Special thanks to Nancy Jones and Yvetta Limon for their work in making this information available on a national basis.

This guide draws from training materials developed by the PHCC—National Association Educational Foundation. The Foundation is a partnership of contractors, manufacturers, and wholesalers committed to serving the p-h-c industry by providing educational tools and preparing contractors and their employees to meet the challenges of a constantly changing marketplace. For more information and tools to help with the issues identified in this overview, please contact a member of the Foundation staff at (800) 533-7694. You can also visit www.phccfoundation.org and look for the “Overhead and Profit Calculator” under the Management Education Section.

© 2012 PHCC of Texas, PHCC-National Association, PHCC Educational Foundation. The source for this guide is the 2012-2013 PHCC of Texas Plumbing Continuing Education textbook, with contributions from PHCC Educational Foundation training materials. Reprinted with permission of PHCC of Texas by the Plumbing-Heating-Cooling Contractors—National Association and PHCC Educational Foundation.

AcknowledgementAbout the Author: Michael Bohinc is a CPA in Cleveland, Ohio and the owner of Keeping Score, Inc. Keeping Score is an accounting, tax and business advisory services firm that Michael started to help small business owners improve their profitability and business operations. He is also an instructor for the PHCC—National Association Educational Foundation. Michael has served as the Chief Financial Officer of Norhio Plumbing, Inc., his family’s plumbing company in Aurora, Ohio for over 20 years. He is also an associate member of the Plumbing-Heating-Cooling-Contractors (PHCC) Association of Ohio and the Air Conditioning Contractors of Ohio.

1 The True Cost of Running A Business www.phccweb.org

IntroductionAccording to recent reports from Profit Cents™ analysis of financial statements of plumbing-heating-cooling contractors, the national industry average net profit was 3.27% for 2010. Why are there such low-profit figures in the industry? Easy answer: Contractors are not properly calculating the pricing for their services based on their actual costs.

Properly figuring your break-even cost and establishing a proper selling price is a fundamental calculation that all contractors need to understand. It’s the financial foundation of the company. If it’s done improperly, anything built upon it will be unstable and may collapse…just like a house with a weak foundation.

The “numbers crunching” process of calculating your break even involves a number of steps. Do not be afraid of this process. Understand that the math processes used here are not too complicated.

Most who venture out on their own simply buy themselves a job as opposed to building themselves a business. How does being a great plumber make you a great plumbing business owner? One has nothing to do with the other. This is exactly how many talented plumbers, HVAC technicians and others fail.

LEARNING OBJECTIVES

Upon completion, you will be familiar with:

• Componentsincludedincalculatingaservicesellingprice

• Identifyingcostsassociatedwithdirectlabor;calculatingthedirectlabor costs associated with running or owning a company

• Theterm“overhead”andcalcuatingthecostsofoverhead

• Theterm“billablehour”andcalculatingbillablehours

• Computingthebreak-evencostonabillablehourbasis

• Themark-upandmarginmethodsofcalculatingasellingprice

• Properlycomputingasellingpriceonabillablehourbasis

Being a business owner in these professions requires as much, if not more, training in business skills (management, marketing, accounting, etc.) as it did in becoming a licensed plumber, HVAC technician, etc.

Throughout this guide, we will look at company information and data from XYZ Service Company, a fictional plumbing-heating-cooling contractor in Austin, Texas. The company is staffed as follows:

• Owner

• Bookkeeper

• CustomerServiceRepresentative(CSR)/Dispatcher

• And5servicetechnicians

For educational purposes only, all the service technicians are paid the same hourly wage, receive the same benefits, work the same number of hours and have the same number of billable and non-billable hours. Real-worldcompanieswillhaveemployeesatdifferentpay rates, receiving varying benefits, working different hours with different billable and non-billable hour breakouts.

The True Cost of Running A Business: An Introductory Guide

The True Cost of Running a Business www.phccweb.org 2

OBJECTIVE 1: Identifying the Components Included in Calculating A Service Selling Price

The mathematical equation for calculating a proper selling price includes the following:

• Materialcosts(M)

• Laborcostsincludingpayrolltaxesandbenefits(L)

• Overheadcostsincludingowner’ssalary(O/H)

• Profit(P)

The equation looks like this:

SP (Selling Price) = M + L + O/H + P

While material costs are a component of a proper selling price, the primary thing that we have to sell is our services (i.e. labor). Our main objective is to determine what we should be charging for our services on a billable hour basis to reach our profit goals. Therefore, for purposes of this discussion, we’re going to set aside the material component.

The equation now looks like this:

SP (Selling Price for Labor) = L + O/H + P

Disclaimer: All figures and prices contained in this presentation are fictitious and for learning purposes only. The tax rates are from the various taxing agencies. Any and all discussion on specific pricing or attempts to fix pricing is prohibited and illegal per the Federal Trade Commission. Michael Bohinc, CPA, Keeping Score, Inc., PHCC– National Association and PHCC Educational Foundation do not condone any attempts to fix pricing.

Did you know?Most contractors, regardless of how they came up in the trades, were given little, if any, instruction on the business side of the plumbing-heating-cooling industry. In the current economic climate, it’s more imperative than ever for contractors to know their numbers! They need to know the true cost of operating a contracting business in the 21st century so they can calculate a proper selling price for their services. They also need to know the proper math formulas to use in calculating those prices. Knowing how to properly calculate selling prices for their services will help contractors make a positive impact on the industry’s pathetic net profit average of three percent (3%).

Q: What is the right price for your services?

A: A dollar amount per bill-able hour that covers ALL of your costs AND profit!


OBJECTIVE 2: Determing Costs Associated with Direct Labor and Calculating Direct Labor Costs

Now, let’s calculate the labor cost per hour per technician. Gather together the payroll data for your field staff. You can, and should, calculate the labor cost for each of your field staff. However, it is recommended that you use the hourly wage rate of your highest paid technician in calculating your direct labor cost so you cover yourself financially.

There’s more than just an hourly wage involved in labor costs of a company. You have to include all of the employment taxes and costs that the company pays on the wages. Then, you have to add in all of the benefits that the company pays the technicians.

Employment Taxes: Employers must match the social security and Medicare taxes that are withheld from their employees’ paychecks.

• Social Security Tax. Employer match is 6.2% with a maximum wage limit of $106,800 (as of 2011). This means the employer pays social security tax on an employee’s wages up to $106,800. (NOTE: In 2011, the social security tax rate for the employee was reduced from 6.2 to 4.2 %. Congress extended this temporary reduction through 2012.) The employer match rate remains at 6.2%.

• Medicare Tax.Employer’smatchis1.45%withnomaximumwagelimit. This means the employer pays Medicare tax on the employee’s wages no matter how much they make.

• Federal Unemployment Tax (FUTA). The employer pays federal unemployment taxes on the first $7,000 of each employee’s wages at a rate of 6%. The federal government gives employers’ credit for unemployment taxes paid at the state level so, in most cases, the actual federal unemployment tax rate is .8%.

• State Unemployment Tax (SUTA). The employer pays state unemployment taxes, usually a few percentage points on the first few thousand dollars of each employee’s wages. Most states have a sliding scale depending on the company’s experience rating.

• Workers’ Compensation. The employer pays workers’ compensation on the wages paid out to their employees. The rates are based on the industry’s standard premium rate and employer’s experience rating (experiencemodificationrating).Companieswithmoreand/orlargerinjury claims will pay higher workers’ compensation premiums than a company with fewer claims.

Employee Benefits: After calculating the employment taxes that the employer is required to pay, you need to calculate all of the employee benefits that the company pays. Companies that want to attract and retain talented employees offer more comprehensive employee benefit packages. There are many benefits that they may offer their employees. For purposes of this chapter, we’ll focus on the most common ones offered.

• Paid Time Off (PTO).Recently,moreemployersaremovingtoapolicythatsimplylumps all the various types of paid time off together into one general account for each employee. Typically, this is broken up into:


• Paid Holidays. Traditionally, employees are paid for six to eight holidays a year.

• Paid Vacations. These are normally based on a person’s length of service to a company, but may be calculated other ways as well. Paid vacation days can be anywhere from just a few days to as much as 6 to 8 weeks a year depending on the company.

• Paid Sick Days.BureauofLaborStatisticsdatashowsthe average blue-collar worker getting nine days sick leave after one year of service.

• Group Health & Life Insurance. This is often the centerpiece of many companies’ employee benefits programs. It is also the one that has changed the most over the last few years. Previously, many companies paid 100% of the premiums for not only their employees but their families as well. That is certainly not the case in most companies today.

According to research done by the Kaiser Family Foundation, the average cost of a family policy offered by employers was $13,770 in 2010, up 3% from 2009. The annual survey of more than 2,000 companies also found that 46% of small-business employees enrolled in individual health plans pay annual deductibles of $1,000 or more. That’s almost twice the number who paid that much in 2007.

Since2005,workers’contributionstopremiumshavegoneup47%, while overall premiums rose 27%, wages increased 18%, and inflation rose 12%. On average, workers paid nearly $4,000 in 2010 toward the cost of their family health coverage.

“With the economy struggling, businesses have been shifting more of the costs of health insurance to workers through premiums, deductibles and other cost-sharing,” Kaiser President and CEO Drew Altman, Ph.D., said. “This may be helping to stem the rapid rise in premiums that we saw in the early 2000s, but it also means employer coverage is less comprehensive. From a consumer perspective, the cost of health insurance just keeps going up faster than wages.”

• Vision and/or Dental Insurance. With health care costs and insurance continuing to increase, many employers have had to make tough choices with their vision and dental programs. According to the 2010 Annual Survey of Employer Health Benefits by the Kaiser Family Foundation, only 18% of companies offer or contribute to vision insurance while 47% offer or contribute to dental insurance. Companies looking to differentiate their benefit packages from the competition will continue to offer vision and dental insurance to their employees.

• Retirement. In the 21st century, workers are going to be increasingly responsible for their own retirement and retirement plans. The days of working for a company for 30 years and retiring with a gold watch and fully-funded, employer-paid pension plan are gone.

“With the economy struggling, businesses have been shifting more of the costs of health insurance to workers through premiums, deductibles and other cost-sharing,” Kaiser President and CEO Drew Altman, Ph.D., said. “This may be helping to stem the rapid rise in premiums that we saw in the early 2000s, but it also means employer coverage is less comprehensive. From a consumer perspective, the cost of health insurance just keeps going up faster than wages.”

Reference:http://www.healthaffairs.org/press/2010_09_02.php


Corporations are moving from the defined-benefit plans (employer-funded) towards the defined-contribution (primarily employee-funded) plans like a 401(k) plan. It is a plan that allows the employee to make voluntary, tax-deductible contributions to the plan up to certain limits and the contributions may, or may not, be matched by the employer. Companies looking to differentiate their benefit packages from the competition will offer generous retirement plan options to their employees.

• Uniforms. Some contractors include the cost of uniforms as an employee benefit in direct labor cost and some of them include the cost in overhead. As long as it’s included in your cost calculations somewhere, it doesn’t really matter if you include it in direct labor or overhead. For purposes of this chapter and topic discussion, we’re including the uniform costs in direct labor cost.

OBJECTIVE 3: Identifying “Overhead” and Calculating Overhead Costs

For many contractors, it’s easier to give examples of overhead expenses than it is to define the term. Overhead expenses are those expenses incurred by the business whether or not a job is sold. They are costs that can’t be assigned to any specific job. They don’t directly relate to the providing of a service or the installation of materials. They are the costs to maintain the business even if you weren’t doing any work. They are sometimes also called operating expenses or indirect expenses.

You can’t directly charge a customer for repairs made to a service truck. If the transmission in the service truck breaks in Mrs. Brown’s driveway, you can’t charge Mrs. Brown for the cost of the truck repair because it broke down in her driveway. You have to spread that repair cost (as well as all of the other overhead costs) over all of your jobs (all of your customers). Each customer should pay for a portion of the repair via the overhead component of your break even cost per billable hour.

When you start calculating your overhead costs, first determine your (owner’s) salary. Too often contractors pay themselves less than their field staff. Make sure that the salary is reflective of the work that is done as the owner of a contracting company.

To put this in perspective, look at your W-2 and or tax return at the end of the year and divide the amount you earned by the actual hours you worked during the year (Formula: Wages or Salary ÷ actual hours worked). The answer is the effective amount you were paid per hour during the year. You may discover that you’d make more money per hour working for someone else than you earned on your own.

Q: What are Overhead Costs?

A: Overhead consists of the costs that you cannot assign to any specific job. They are the costs to maintain the business that you would still have even if you were not doing any work.


OVERHEAD EXPENSES:

Owners’ Salaries Dues – PHCC

Officers’ Salaries Contributions

Administrative Salaries Accounting Fees

Administrative – Payroll Taxes LegalFees

Administrative – Employee Benefits Other Consultants

Building Property Taxes Office Supplies

Rent/Mortgage–Office Postage

Utilities-Power Travel

Utilities-Water Insurance Expenses

Utilities–Gas/Heat Licenses/Bonds/Permits

Utilities–Phone/Internet Fuel/Gas

Advertising: Yellow Pages VehicleLeases

Advertising: Direct Mail VehicleMaintenance/Repairs/Registration

Advertising:Newspapers/Magazines/Other EquipmentLeases

Advertising:TV/Radio EquipmentMaintenance&Repairs

Internet/WebSite Training

Miscellaneous Expenses

Depreciation Expense

There’s another “expense” that contractors must include in their overhead and break even calculations. It is probably the overhead item that many contractors miss in their break even calculations. It’s also the expense that is a mystery to most contractors. It’s called depreciation.

• Depreciation is an accounting term that is often misunderstood. It is not an expense like fuel, office supplies or association dues where you actually pay out money. Depreciation is a non-cash expense on the income statement. It is an expense that directly relates to the assets of the company and the fact that, over time, the assets lose value. In an ideal setting, a company would set aside funds annually to cover the decline in the value of the company assets. Another way to look at it is as a reserve fund to cover replacing the company assets (i.e. vehicles, etc.) Please note: It won’t cover the actual replacement cost and, remember, it’s a non-cash expense. In my experience, it’s only a small percentage of business owners that actually do set aside funds on an on-going basis to replace their assets (vehicles, equipment, etc.)

OBJECTIVE 4: Identifying and Calculating “Billable Hours”

WHAT IS A BILLABLE HOUR?

A billable hour (BH) is an hour that someone works that is actually chargeable to the client. For example, you spend an hour at Mrs. Smith’s house replacing her garbage disposal. That hour is chargeable to Mrs. Smith and is, therefore, a billable hour. There are hours that


will be spent driving to the jobs, picking up materials, doing take-offs of prints, preparing estimates, attending conventions and continuing education courses, etc. These hours are not billable hours. These are hours that are not directly related to completing work for a client. These hours cannot be directly billed to the client. They are, however, a component of calculating the proper selling price per billable hour of labor.

There are a finite number of hours available to work in the course of a year. Eachofushas365daysayearand24hoursaday.Nomoreandnoless.Astandard 40-hour work week for the year means that you would work 2,080 hours per year. However, with paid time off for holidays and vacations, most people don’t actually work the full 2,080 hours. For example, If an employee receives paid time off for 8 holidays, 10 days vacation, 3 days sick pay and 3 training days, it totals 192 hours that are not billable. That leaves only 1,888 hours during the year to work and possibly bill out. It is virtually impossible to work and bill out all those hours because of the hours mentioned above spent on unbillable tasks.

You will not bill out 1,888 of 2,080 hours in a year. It is impossible. There will be hours spent driving to the jobs, picking up materials, pricing estimates and doing take-offs from blue prints, attending industry conventions and seminars on technical and business topics, etc. These all subtract hours from the 1,888 hours total available to bill. If you’re a service and repair plumber, most of your workinvolvesdrivingaroundtownfromonejobtothenexteveryday.Rarely

will you spend a full day or more on one job.

Anaverageforbillablehoursis4hoursforeach8-hourday(or50%billable).Ofcourse,youmust not base your pricing on that percentage unless it is applicable. Instead, calculate what your actual billable hour percentage is or the number of hours you actually bill out in a year. If you do not have the records and information to calculate the billable percentage, start to track the information and garner an actual billable percentage. In the meantime, you could choosetousethe50%figureuntilyouaccumulateenoughactualdatatodeterminethetrue billable percentage. It would be moreaccuratetousethe50%figurerather than a 60, 70 or 80% figure to calculate the break even cost per billable hour until you calculate your company’s actual billable percentage. That reduces the chance that you’ll under calculate your break even cost per billable hour. There are contractors who average more than the50%billablefigureandotherswho average less than that.

If you’re a residential construction or commercial contracting company where you spend all day on a job site, then an average for billable hours is 6 hours for each 8-hour day (or75%billablepercentage).Again,

Q: What is considered Billable Time? A: Time that can be directly charged to customers.Examples: Installing a water heater, performing a service call or hanging duct.

Example: Gary is the sole employee of PHC Home Comfort Systems, Inc. Gary shares the following data from his 2010 business year:

1,144 Hours Gary billed out (Billable Hours)

2,080 Hours in standard work year (52 weeks @ 40 hours per week)

To determine the billable (or productive) percentage, you divide the hours Gary billed by the actual hours worked (1,144 ÷ 2,080 = 55%). This means that Gary spent 55% of his working hours actually performing work for his clients. The other 45% of his time was spent driving to and from the jobs, preparing estimates, picking up materials, doing office paperwork, attending training seminars and conventions and other non-billable tasks.


it’s important that you track your own companies’ billable hours and use that billable percentage. These are just averages based on reviews of financial statement data and discussions I’ve had with contractors.

• Tracking Billable Hours. Regardlessofhowyoubillyourclients(timeandmaterial,flat-rate pricing, job pricing, etc), a simple log or a spreadsheet that tracks each and every job you do should be kept. You can get as detailed as you like but, at a minimum, record the number of hours that you bill out for each job or each task and also the number of hours actually spent on the job. In a time and material system, every hour worked on the job is being billed out. Travel time and other shop time are handled a variety of ways but should be accounted for somewhere in the billing fees.

In a flat rate system, each task is set up with a standard number of hours for that job…whether it’s installing a garbage disposal, snaking a toilet, replacing a condenser fan motor, etc. The hours that are billable on each task are the hours that are built into the task price. It doesn’t matter if it takes the employee more or less time than the standard hours for the job. The billable hours are the standard hours set up for that task. If a task had 2 hours built into it and the employee took only 1 ½ hours to do the job, it would be 2 billed hours on the job. If the employee took 3 hours to complete the task, it would still only be 2 billed hours. There are a number of software programs available for the p-h-c industry that track all of this information and do the calculations automatically for you.

Tracking the billable and actual hours worked by each field employee allows you to calculate their respective billable percentages as well as the billable percentage for each department and the company as a whole.

OBJECTIVE 5: Computing the “Break Even” Cost on a Billable Hour Basis

Recallthesellingpriceequationfromanearliersection:

SP (Selling Price for Labor) = L + O/H + P

Since that’s the equation for determining the selling price for a billable hour of labor (not for determining the break even cost for the company), remove profit from the equation, making the equation:

Break Even Cost per Billable Hour = Labor cost per billable hour + O/H cost per billable hour

BE Cost per BH = DL Cost per BH + O/H Cost per BH

The first step in calculating the break even cost per billable hour is to calculate the labor costperbillablehour(DLCostperBH).Todothis,thetotaldirectlaborcostsandbillablehoursforXYZServiceCompanyareneeded.Let’ssaythatthetotaldirectlaborcostsforXYZ Service Company for the year are $341,110 (following the steps learned in Objective 2). Thebillablehoursare5,735(followingthestepslearnedinObjective4).Dividethetotal direct labor costs by the billable hours for the company. According to the calculations be-low,XYZServiceCompanyhas$59.48inlaborcostsforeveryhourthecompanybillsout.

Total DL Costs ÷ Billable Hours = DL Cost per BH

$341,110 ÷ 5,735 = $ 59.48 DL Cost per BH


The next step in determining the break even cost per billable hour is the overhead component. To do this, we need the total overhead costs for XYZ Service Company as well as their billable hours for the year again. The overhead costs for XYZ Service Company are $476,084 (following the steps from Objective 3). The billable hours for the company are 5,735(fromObjective4).Todeterminetheoverheadcostperbillablehour,dividethetotaloverhead costs by the billable hours for the company. According to calculations below, XYZ Service Company has $83.02 in overhead costs for every hour the company bills out.

Total O/H Costs ÷ Billable Hours = O/H Cost per BH

$476,084 ÷ 5,735 = $ 83.02 O/H Cost per BH

Themethodofoverheadrecoveryusedinthischapterissinglesource—labor;meaning, all overhead costs are recovered by way of labor component pricing. Overhead costs, therefore, are not allocated to the company’s material component pricing.

Question: What is our break even price per billable hour?

All Labor + Overhead = Total Costs* Costs* Costs*

$59.48 $83.02 $142.50

These are the dollars per bIllable hour required just to break even.

We have not made any profit yet!

OBJECTIVE 6: Mark-up and Margin Methods

IMPORTANT NOTE: Our discussion will center on proper pricing strategies and not on specific prices to charge or use. That is price-fixing and is an illegal practice. This discussion is not a discussion of prices but, rather, of pricing methods and how to properly calculate the selling price for an hour of labor.

• Mark-up–iscalculatedbasedonthecostofaproductorservice.

• Margin–iscalculatedbasedonthesellingpriceofaproductorservice.

Contractors often use these terms interchangeably, thinking they mean the same thing but theydon’t.Contractorssaysomethinglike“Imade15%markuponthejob.”Theythinktheymadea15%profitonthejob.However,theircalculationswerebasedonmultiplyingtheirjobcostsby15%.Inreality,theprofitpercentagemadeonthatjobwassignificantlylessthan15%.

An example may clarify the difference in the two terms. After the answers are calculated, the proofsareshownforeachmethod.Remember,thesearemathequationsandareprovable.


Example: Remember Gary, the sole employee of Home Comfort PHC Services? Well, Gary’s got a project he’s bidding on. He’s calculated his total cost (materials, labor and overhead) on the project to be $1700. Gary decides he wants to make 15% profit on the project. Let’s calculate the selling price for Gary:

Mark-up Method (based on job cost)Formula: Job Cost + (Job Costs x Markup %) = Selling Price

$1,700 [job cost] x .15 [15% profit] = $255 mark-up [profit]

$1,700 + $255 = $1,955 selling price for the project

Proof of calculation:

$1,955 selling price - $1,700 project cost = $255 profit.

Next, we take the profit amount and divide it into the project’s selling price to find the profit percentage.

$255 ÷ $1,955 = 13.04%

Wait, what happened? Gary’s goal was 15% profit on the project. However, because he calculated his profit using the mark-up method, his actual profit percentage was only 13.04%!

Now that we’ve explained the mark-up method to you, we are going to ask you to forget the term. When you use the mark-up method improperly, you reduce or eliminate any potential profits on the project. Do not use the term mark-up or the mark-up method. Use the margin method. It is simple and always accurate. By the way, do you wonder why builders, general contractors and others use the markup method? Well, the math above explains why. It produces selling prices that are lower than they would be using the proper method. Many contractors failed to reach their profit goals because they confused the terms (and calculations) mark-up and margin. They cannot be used interchangeably! This is how contractors continually short-change themselves.

The Margin Method is based on the selling price. Since the selling price is unknown, use theinformationthatisknown.Wewantamarginof15%.Thatmeansthatthecostsmustequal85%sincethesellingpriceis100%.Themathtermforthisisreciprocal.Apairofnumberswhosetotalequals1.Inthiscase,.15+.85equals1.00.Ifthemargingoalwas20%, the costs must equal 80%, margin goal of 10%, the costs must equal 90%, etc.


Mark-up Method (based on job selling price)

Formula: Material+Labor+OverheadCosts Selling Price = (100% – Margin % desired)

$1,700 SellingPrice= (100%–15%)

$1,700 SellingPrice= .85

Selling Price = $2,000

Selling Price – Job Costs = Profit

$2,000 - $1,700 = $300

Profit ÷ Selling Price = Profit %

$300÷$2000=15%

Thinkofthismathequationasapie(apple,peach,pizza,etc.)Thewholepieisyour sellingprice.Asliceofthepieequalto15%isprofit.Thatleaves85%ofthepie.Thatpartof the pie must be the cost. When you see the sale ads in the Sunday paper, they advertise prices based on a percentage off of the normal selling price. They don’t base it on a percentage of the COST of the product or service. For example, a business suit is advertised at25%offitsregularpriceof$400(i.e.25%offof$400regularpriceORpriceyoupayis$400*.75=$300).Thissameprincipleappliestothep-h-cindustryaswell.Remember,profit must be calculated as a percentage of the selling price, not the direct cost.

OBJECTIVE 7: Computing a Selling Price Based on Billable Hours

In order to calculate a proper selling price for an hour of labor, we must decide on the profit percentage we’d like to make for our services. As noted at the beginning of the chapter, the current average net profit margin for the industry is about 3%. Currently, the rate of return on bank CDs is right around 1%, which is near all-time lows. Both of these percentages are extremely low rates of return. An investment in Home Depot would earn youareturnof5%.Hereareprofitpercentagesforotherselectcompanies:WaltDisney–10%;McDonald’s–21%;Wal-Mart–4%;Google–29%;ComericaBank–11%; Exxon-Mobil – 8% and Microsoft – 33%.

There are many reasons why people go into business for themselves, but the primary reason is to make more money on your own than you could by working for someone else. Therefore, as a business owner, you probably wouldn’t set a low profit margin. Decide what you feel is a fair rate of return for your hard work and investment. For purposes of discussion, let’ssayyousetyourprofitgoalat15%andyouworktowardsitbutdon’treachitattheend of the year. You only hit 9%. Hey, that’s still 6% higher than the industry’s average


of 3%. Our point here is to aim high! Don’t settle for a 3% profit. Think about it this way. Would you keep your investment in the stock market, mutual funds or retirement plan that constantly earned only a 3% return? So, why would you settle for that with your own company? We strongly encourage you to hold your own business just as accountable as far as the profitsgoasyoudoforyourotherinvestments,IRAsandretirementplans.Ifyoufeelthata10%returnonyourIRAisanaveragereturnthenthatcouldalsoapplytoyourbusiness.

TheownerofXYZServiceCompanydecidesthata15%profitmarginisthegoalforthecompany. Based on that information, let’s calculate the selling price per billable hour of laborfortheXYZServiceCompany.Remember,theequationis:

SP per BH = DL per BH + O/H per BH (100% – 15%)

SP per BH = $59.48 + $83.02 .85

SP per BH = $142.50 .85

SP per BH = $167.65

Selling Price Calculation: XYZ Service Company

Break Even cost per billable hour . . . $142.50

Profit Goal (15%) . . . . . . . . . . . . . . . . $25.15

Selling Price per billable hour . . . . . . . $167.65

XYZServiceCompanymustcharge$167.65foreveryhourtheybillouttocoverallofthecostsofthecompanyplusa15%profit.Anythinglessthanthatamountperbillablehourand they come up short of their goals. The more hours sold at a lower amount, the quicker that XYZ will find themselves in financial trouble. Cash flow can only keep a contractor who does not charge enough to cover his costs open for so long.

Realistically,it’sasignificantchallengetoquoteyourhourlyratetoyourcustomers.Theysay that people’s perceptions are our reality. When people are quoted an hourly rate like thatofXYZServiceCompany’s($167.65),theyareshockedbecausetheperceptionisthatthepersonismaking$167.65perhour.Weknowthat’snottrue.Actually,ifyourecall,inXYZ’scase,thetechnicianismaking$25perhour.Frankly,manypeopleareshockedormake judgments on contractors who quote hourly rates that are lower than XYZ’s. Selling your correct hourly rate to your customers is based on the total service experience you bring into their homes and businesses.

That’s why, when faced with the reality of the true hourly cost of operating their p-h-c company, many service contractors convert their billing system over from time and material to a flat-rate, total job price or one-price system. There are a number of things that go into delivering outstanding service and becoming a top-notch contractor. That is a separate


program on its own, and is not covered in this material. This guide’s focus is specifically on how to properly calculate the true cost of operating a p-h-c company and develop a selling pricebasedonthosecalculations.Remember,thesemathcalculationshavealargeimpacton the financial health of your business. Do not be intimidated by the numbers. Educate yourself. You do not need have an accounting degree to understand what you need to know. Talk with your bookkeeper, controller or CPA about these issues. Don’t financially sell yourself short.

ConclusionProperly figuring your break-even cost and establishing a proper selling price is a fundamental calculation that all contractors need to understand. It’s the financial foundation of the company. If it’s done improperly, anything built upon it will be unstable and may collapse…just like a house with a weak foundation. With a firm understanding of the concept of break even and calculating proper selling prices, contractors will help dramatically improve the industry’s pathetic 3% average net profit margin.

A note from the author, Michael Bohinc, CPA:

These days, with the multitude of home improvement stores (Home Depot, Lowes, Menards, etc.) out there, there are no guarantees that you will be selling materials to your customers. There has been an increase of install-only work in the industry. It is more difficult to get higher margins and multipliers on the materials like it was in the past because of these stores. The stores are purchasing such huge quantities of materials from the manufacturers that they are able to offer the items to the general public at prices lower than industry suppliers can purchase them. The margins on many items have been squeezed significantly over the years because of the proliferation of these home improvement stores.

Because of this situation, I advocate that you recover all of your overhead costs through your labor. Why? If you apply a portion of your overhead costs on the materials you sell, what happens when a customer calls and asks you to install a sink, faucet and garbage disposal for them that they purchased at Home Depot or Lowes? They are supplying the materials for this job so that any overhead cost recovery that you normally apply to your material sales is gone. At this point, it’s tough to go back and cover that in your labor cost for the job. What happens to the job with this overhead shortfall? Who gets “short-changed” in this scenario? The contractor does. I’m not suggesting you don’t apply a margin to the material portion of the sale, just make sure all of the overhead is recovered through the labor portion. Anything you make on the material portion of the sale will go straight to the bottom line.

A couple of notes on this method of overhead cost recovery. If a job is labor-intensive (mostly labor with little or no materials), it’s possible that you may overbid the job because all of the overhead has been recovered through labor. If a job is material-intensive (mostly material with little labor), you may underbid the job and lose money because a low amount of overhead will be recoveredthrough the labor component and no overhead is recovered through the materials. This is why some contractors are using the dual-source overhead recovery method to allocate their overhead costs. Under this method, overhead is recovered (and allocated) to both the material and labor components of the job. Because this method is more complicated and often miscalculated, it is not covered in this overview.

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