$15,000 phone call

Author’s note: This article was taken from the author’s book, A Critical Analysis of the MORS Estimating System.

In my last article I stated, “Cost estimating is all about estimating your costs accurately.” Sounds like circular reasoning, but it’s true. There are two types of costs — direct (job materials, field labor and burden, trucks and equipment, and subcontractor costs) and indirect (your light bill, office staff, marketing, rent and so forth). The overview for a project that you install or a service that you provide is as follows:

Direct costs

+ Indirect costs (general and administrative [G&A] overhead)

+ Net profit margin

= Final price

Note: 1. Direct costs + indirect costs = Breakeven point (BEP)

2. Indirect costs + net profit margin = Gross profit margin (GPM)

More bad arithmetic

Traditional estimating systems (and software) typically use percentages multiplied by direct costs to allocate G&A overhead costs in their pricing models. This is a mistake. The question is, “Where do these percentages come from, and how do you justify them mathematically?” The short answer is, “You can’t.”

In the previous article, I explained why the traditional 10% markup applied to material costs for allocating G&A overhead to your pricing (bids) isn’t accurate. Now I want to address the traditional 5% markup applied to subcontractor costs in order to allocate G&A overhead costs to them. Net profit is then added on top of the 5% markup.

Traditionally, subcontractor costs in a bid are marked up 5% to cover the cost for processing subcontractor proposals and coordinating with, paying and billing for subcontractors. Net profit, normally 5-15%, is added to the 5% as a markup. The total for the two, which normally ranges from 10-20%, is your gross profit margin (GPM) on this portion of the project. GPM is the difference between the cost that you pay the subcontractor subtracted from the price that you charge the client for the subcontractor’s work.

I’ve worked with hundreds of contractors throughout North America and the typical GPM put on subcontractor costs is 15%. Few contractors ask how much of this 15% goes for G&A overhead costs or net profit. They intuitively know what the market will allow them to get away with. It’s not very analytical, but it works. Let me use an actual example to illustrate.

A contractor on the East Coast was bidding a landscape project to a developer. The portion of the job that he was going to do with his crews totaled $36,000. However, he had a quote from a subcontractor to do $100,000 of dirt and erosion prevention work on the project. He called me asking how much he should add to the subcontractor cost for G&A overhead and net profit. He told me that he normally added 5% for G&A overhead and 10% for net profit to such a job. He was leaning toward marking up the $100,000 by 15% ($15,000).

I asked my client how much experience he had with this particular subcontractor and how much of his time he would spend supervising him. He knew the subcontractor very well and that he had a very good reputation for doing this kind of work. My client added that when it came time for the subcontractor to do his portion of the job, all he had to do was call the subcontractor to tell him when to start and, once finished, send an invoice for his work to the developer.

“Let me get this straight,” I said to my client. “You want to charge $15,000 to make a telephone call and send an invoice in the mail. Right?” Jokingly, I offered to make the telephone call and split the $15,000 with him.

“If the market will let you get $15,000 for making a telephone call and sending an invoice, by all means, do so,” I told him. He saw my logic and decided to settle for 5% or $5,000. Not bad pay for making a telephone call and preparing an invoice!

All about the net

I could provide numerous examples showing you why the 5% markup traditionally applied to subcontractor costs for G&A overhead cost allocation simply isn’t accurate. It’s fictitious and has no mathematical justification whatsoever. I won’t trouble you to explain why the 25% markup applied to truck and equipment costs to allocate G&A overhead costs to them is equally specious.

I tell clients not to worry about how much of the gross profit margin added to subcontractor costs is G&A overhead or how much is net profit. Focus on the total. In my estimating system, it’s all net profit anyway. In addition, the market (customer) doesn’t care how much of the GPM is overhead or profit.

Next time I’ll explain why gross profit margin is the important thing to focus upon, not G&A overhead percentages multiplied by direct costs. I’ll also explain how you can calibrate and compensate for any software system that uses percentages to allocate G&A overhead costs to your pricing.