Both require that you estimate thenumber of hours to complete the job. If you miss thehours, you will miss the estimate. Then, either your jobwill 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 estimatedcost for equipment and materials is $1,000. What isthe selling price to the customer?
Using the gross margin method:
Total labor cost = 16 hours x $40 per hour = $640
Total equipment/material cost = $1,000Total 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 wherethe labor cost and material cost are close. Let’s lookat what happens when you have a high materials costsituation (Exercise #2) and a high labor cost situation(Exercise #3).
Exercise #2:
You estimate a job will take 16 hours. The estimatedequipment and materials is $2,000. What is the sellingprice 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 perhour basis would win the job. The contractor biddingon a gross margin basis would say that he couldn’t dothe job for that price. He wouldn’t realize that his estimatedprofit was $1,022. To meet the other contractor’sprice, he would have to lower his gross margin to25 percent, which he thinks would be an unprofitablejob 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 = $1,000Total 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 (totaldirect 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 methodyou’ll only make a $428 profit on the job. The contractorusing the net profit per hour method keepshis profit per hour consistent at $30 per hour or hecan choose to lower his net profit per hour to meet thecompetition.The high labor jobs are dangerous to use gross marginto calculate sales price. Let’s take Exercise #4:For Exercise #4, let’s say that Exercise #3’s job actuallytook 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 onthis 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 perhour was approximately $10 per hour rather than theestimated $30 per hour. However, the job was stillprofitable.It is much better to calculate your overhead costper hour for each department and use it to calculateyour selling prices to the customer. Assuming thatyou estimate your labor hours correctly, you’ll have aconsistent net profit per hour worked. If you miss anestimate, you’ll still have enough profit in the job tosurvive.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and become more profitable. She is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. Ruth has written two books: The Ugly Truth About Small Business and The Ugly Truth About Managing People. Contact Ruth at ruthking@hvacchannel.tv or 770.729.0258.
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