Facebook Twitter LinkedIn Google+


Sales Price Using Net Profit Per Hour, Part 2

Originally published: 08.01.06 by Ruth King


Last month, I described how to calculate your selling price based on net profit per hour calculations. This month, I'll give you examples of how to better estimate your selling price to the customer.

Whether you calculate your prices on a gross margin basis or net profit per hour basis, you must have accurate labor costs. Both require that you estimate the number of hours to complete the job. If you miss the hours, you will miss the estimate. Then, either your job will be at a loss or wildly profitable.

Assumptions:
Hourly cost is $40 per hour (including burden)
Overhead cost is $25 per hour
Desired profit is $30 per hour
Gross margin is 35 percent

Exercise #1:
You estimate a job will take 16 hours. The estimated cost for equipment and materials is $1,000. What is the selling price to the customer?

Using the gross margin method:
Total labor cost = 16 hours x $40 per hour = $640
Total equipment/material cost = $1,000
Total direct cost = $1,640

Selling price


to the customer = $1,640 ÷ .65 = $2,523
The total direct cost ($1,640) is divided by 1 - .35 or .65 (the gross margin).

Using the net profit per hour method:
Total labor cost = 16 hours x $40 per hour = $640
Total equipment/material cost = $1,000
Total overhead cost = 16 hours x $25 per hour = $400
Total profit = 16 hours x $30 per hour = $480

Selling price to the customer = $2,520

The results for Exercise #1 are typical for cases where the labor cost and material cost are close. Let’s look at what happens when you have a high materials cost situation (Exercise #2) and a high labor cost situation (Exercise #3).

Exercise #2:
You estimate a job will take 16 hours. The estimated equipment and materials is $2,000. What is the selling price to the customer?

Using the gross margin method:
Total labor cost = 16 hours x $40 per hour = $640
Total equipment/material cost = $2,000
Total direct cost = $2,640

Selling price to the customer = $2,640 ÷ .65 = $4,062
The total direct cost ($2,640) is divided by 1 - .35 or .65 (the gross margin).

Estimated profit: $4,062 (selling price) – 2,640 (direct cost) – 400 (overhead cost) = $1,022

Using the net profit per hour method:
Total labor cost = 16 hours x $40 per hour = $640
Total equipment/material cost = $2,000
Total overhead cost = 16 hours x $25 per hour = $400
Total profit = 16 hours x $30 per hour = $480

Selling price to the customer = $3,520

In this case, the person estimating on a net profit per hour basis would win the job. The contractor bidding on a gross margin basis would say that he couldn’t do the job for that price. He wouldn’t realize that his estimated profit was $1,022. To meet the other contractor’s price, he would have to lower his gross margin to 25 percent, which he thinks would be an unprofitable job when in actuality it wouldn’t be.

Exercise #3:
You estimate a job will take 32 hours. The estimated equipment and materials is $1,000.What is the selling price to the customer?

Using the gross margin method:
Total labor cost = 32 hours x $40 per hour = $1,280
Total equipment/material cost = $1,000
Total direct cost = $2,280

Selling price to the customer = $2,280 ÷ .65 = $3,508
The total direct cost ($2,280) is divided by 1 - .35 or .65 (the gross margin).

Estimated profit: 3,508 (selling price) – 2,280 (total direct cost) – 800 (overhead cost) = $428

Using the net profit per hour method:
Total labor cost = 32 hours x $40 per hour = $1,280
Total equipment/material cost = $1,000
Total overhead cost = 32 hours x $25 per hour = $800
Total profit = 32 hours x $30 per hour = $960

Selling price to the customer = $4,040

In Exercise #3, by using the gross margin method you’ll only make a $428 profit on the job. The contractor using the net profit per hour method keeps his profit per hour consistent at $30 per hour or he can choose to lower his net profit per hour to meet the competition.

The high labor jobs are dangerous to use gross margin to calculate sales price. Let’s take Exercise #4:

For Exercise #4, let’s say that Exercise #3’s job actually took 40 hours to complete instead of 32. What happened?

Total labor cost increased to $1,600.
Material cost stayed the same at $1,000.
Total overhead cost increased to $1,000.

Using the gross margin calculation the profit is:
$3,508 (selling price) – 2,600 (revised direct cost) – 1,000 (overhead cost) = - $92. You lost money on this job.

Using the net profit per hour calculation
:$4,040 (selling price) – 2,600 (revised direct cost) – 1,000 (overhead cost) = $440. The net profit per hour was approximately $10 per hour rather than the estimated $30 per hour. However, the job was still profitable.

It is much better to calculate your overhead cost per hour for each department and use it to calculate your selling prices to the customer. Assuming that you estimate your labor hours correctly, you’ll have a consistent net profit per hour worked. If you miss an estimate, you’ll still have enough profit in the job to survive.

Ruth King, a nationally-known HVACR industry expert who writes this column for HVACR Business can be contacted at rking@hvacrbusiness.com.


Articles by Ruth King

Understand Your P&L Statement: Gross Margin

While gross profit can vary widely from month to month depending on how busy your company is, gross margin should not vary more than a few points each month.
View article.

 

Understand Your P&L Statement: Cost of Goods Sold

However you decide to categorize expenses in your P&L, it's important to be consistent.
View article.

 

Understand Your P&L Statement: Sales vs. Revenue

Sales are critical to survival — when revenue is actually generated is even more critical.
View article.

 

The 20 Percent Profit Myth

For a realistic goal, include owners’ compensation in the net profit equation.
View article.

 

Rethink Your Bonus Strategy

Enact a profit sharing program, rather than a bonus entitlement.
View article.