The Science of Pricing Your Projects
authors Dan Luck | June 11, 2021
As you prepare for a post-pandemic world, are you positioned to manage the anticipated demand for your products and services? For example, homeowners forced to look at tired spaces during the isolation now want to change their kitchen or bathrooms.
With this increased traffic, do you know how much you should charge for your products and services? When asked, dealer responses range from whatever the market can bear to copying a markup formula used from the last project sold.
The truth is, most dealers are undervaluing their jobs by at least 15%. On a $2,000,000 operation, that’s $300,000 being left on the table.
Of course, when told that his/her firm needs at least a 15% price increase, the owner or manager’s reaction is “it can’t be done; we’re already the most expensive kitchen and bath company in town.” So, they continue this limiting belief, holding fast to the idea that increased prices equates to lost sales.
There is a science to pricing your projects. The proper price formula will be different for every operation and is a function of three things: (a) a “market rate” owner’s salary, (b) the firm’s overhead, and (c) the desired Net Profit. And it has everything to do with developing an accurate budget for your business.
The primary purpose of a price formula system is to collect the gross profit dollars established in an annual budget.
Determining the correct price formula for a studio model business is relatively straightforward. First, divide a project’s total cost by the same percentage as the firm’s budget for the cost of sales (COGS).
Project Costs = $ 40,000
Cost of Sales from Budget = .59
Sell Price = $ 67,797
The price formula system for a showroom model kitchen and bath firm is more involved and should consist of three parts: a) calculation of the production overhead (burden) rate, b) calculation of the respective markups for each business mix category, and c) establishment of a service contingency fee.
BURDEN RATE CALCULATION
The labor used to install a kitchen or bath is typically referred to as a direct labor expense and can be easily identified and posted to a specific job. However, many indirect costs associated with a project are not easily identified, such as project manager’s salary, warehousing costs, shop supplies, payroll taxes, to name a few. As a result, these expenses are usually missed and not captured as a cost into the project.
Without capturing these additional expenses, it would be overpaying commissions owed to the sales designers and under-collecting the proper dollars needed for the firm’s overhead.
Step #1: The First Step in calculating a burden rate is to subtract highly competitive cost items from the total cost of sales – items that can’t get close to an entire markup. For example, appliances may fit this highly competitive category.
Total Projected Revenue = $ 2,100,000
Less Gross Profit – $ 861,000
Total Cost of Sales $ 1,239,000
Less Appliance Cost of Sales – $ 242,500
Sub-Total Cost of Sales = $ 996,500
Step #2: Next, subtract the total production overhead from the sub-total cost of sales. Let’s assume the production overhead for this $2,100,000 example is $105,000.
Sub-Total Cost of Sales = $ 996,500
Less Production Overhead – $ 105,000
Net Cost of Sales = $ 891,500
Step # 3: Divide the budgeted production overhead by the net cost of sales and round up.
Production Overhead = $ 105,000
Net Cost of Sales = $ 891,500
= 11.77% (12%)
For this example, a burden rate of 12% should be added to the cost of sales (including material costs, use tax, direct labor and any subcontractor costs) exclusive of any highly competitive items as noted earlier.
It’s important to periodically test the burden rate quarterly for accuracy and make adjustments up or down accordingly.
The markup is intended to finance the collection of the Sales & Administrative Expense, Other Income/Expense and the Net Profit established in the budget. Most dealers sell to different markets, so you will probably need different markups based upon your expected business mix.
Using the hypothetical $2,100,000 operation again, view the Pricing Strategy Chart above depicting the necessary Minimum Markups for four different market categories.
The imperfect nature of the business, where there can be many sources of human error even with good controls in place, requires there to be an allowance for gross profit slippage. Within the market mix some, like bathrooms, are more difficult to produce, and thus, an adjustment to the markup is required to account for potential slippage.
Providing sales designers markup flexibility within each category allows them to tailor the pricing to fit the situation. For example, suppose compensation is based upon a percentage of the gross profit of the job. In that case, good sales designers will always seek to achieve the highest markup, especially if they sense the client will need a lot of hand holding through both the design and installation stages.
The third and final component of an effective pricing system relates to servicing a job within the typical one-year warranty. This cost should not be posted to the Cost of Sales because presumably the job was closed and the commission paid to the sales designer. Instead, it should be assigned to an account called “Warranty Service” located “below the line” on your Profit & Loss Statement in an area known as Other Income & Expenses.
To finance the collection of Warranty Service expenses, a 1-3% Service Contingency should be added to every job after the Burden Rate and Markup.
The purpose for establishing a pricing system is simple; to collect the gross profit dollars found in the annual budget. A Company’s Pricing Policy is a financial function tied directly to its yearly budget. The company must collect the Gross Profit Dollars as specified in the budget to finance the Overhead & Net Profit at the desired revenue goal. It’s important to remember that each job sold contributes to a gross profit dollar goal.
Once a dealer understands the science behind pricing projects, with proper execution the path is clear in reaching your financial objectives. ▪
Dan Luck owns Bella Domicile in Madison, WI. He has been an SEN Member since 2002 and has led the SEN Leadership Team since 2018. Visit sendesigngroup/education for more information. Dan welcomes questions and comments at [email protected]