There are many methods used to price jobs. This article examines five of the more common methods used today in the market place. The important thing to keep in mind is to first correctly identify all costs (the breakeven point) and then add profit and any necessary contingency factor to those costs.
For comparison of the following five pricing methods, we will use the two following jobs as examples:
| Job A | Job B | |
| Materials | $100,000 | $40,000 |
| Labor with labor burden | 15,000 | 60,000 |
| Equipment | 5,000 | 20,000 |
| Subcontractors | 0 | 0 |
| Total direct costs | $120,000 | $120,000 |
| OPH | $7.50 | $7.50 |
| PPH | $5.00 | $5.00 |
| Labor Hours | 1,500 | 6,000 |
| CAW | $10.00 | $10.00 |
| (with 33 percent labor burden) | ||
THE FACTORING OR MULTIPLIER METHOD. Using this method, contractors multiply estimated material costs or material and labor costs by a "factor." The factor may be based on past profit and loss statements or it may be a number arrived at by monitoring past bids. The rationale is: If you ended a previous year with a sufficient profit, and if material costs were 33 percent of gross sales for that year, then all you have to do is multiply material costs for the new year by a factor of 3.0. Supposedly, this will produce prices that will ensure sufficient profit.
Sales taxes, field-labor burden, profit and overhead are all included in the factor. A contingency factor may be applied to the job, but not always. This is a highly flawed method, but many landscape and irrigation contractors bid work using this "material-times-two" approach. The only variables addressed in this method are the amount of materials and the factor.
Unfortunately, it does not address other variables that usually apply. Some of the items that may change from job to job and that need to be dealt with separately in the estimating process are:
- General conditions
- Profit markup
- Site conditions
- Types of equipment
- Subcontractors
- Labor rates
If we use the mythical method of material times a factor of two, our prices for jobs A and B are $200,000 and $80,000, respectively. As we continue our analysis of the other common pricing methods, the flaws of factoring will become quite apparent.
| Job A | Job B | |
| Materials | $100,000 | $40,000 |
| Factor | x 2.0 | x 2.0 |
| Price | $200,000 | $80,000 |
THE GROSS PROFIT MARGIN METHOD. There are a number of popular derivatives of the gross profit margin approach to pricing, which is also called the single overhead recovery system method. Although it has some merits and applications, virtually all of these positives are only useful when they are incorporated into other, more accurate and flexible, estimating methods. And, like factoring, the GPM/SORS method is useful for the purposes of "hindsight" analysis.
Two of the more popular applications of the GPM/SORS pricing method are: The 1/3, 1/3, 1/3 Rule
Although the specific fractions may change, their use is the same. The estimator, after reviewing past profit and loss statements, determines that material costs have comprised approximately 33 percent of gross sales. Labor, with burden, and possibly equipment costs, account for another 33 percent. The remaining 33 percent covers equipment costs, if not combined with labor, overhead and profit.
| Job A | Job B | |
| Materials | $100,000 | $40,000 |
| (33.3%) | (33.3%) | |
| Labor Burden | $100,000 | $40,000 |
| and Equipment | (33.3%) | (33.3%) |
| Subtotal | $200,000 | $80,000 |
| (66.6%) | (66.6%) | |
| Overhead | $100,000 | $40,000 |
| and Profit | (33.3%) | (33.3%) |
| Total Price | $300,000 | $120,000 |
GPM Markup Method.
Although similar to the previous technique, the GPM markup method requires contractors to do more homework. You must first accurately identify specific costs for material, labor, equipment (unless included in labor or overhead) and subcontractors. Sales taxes are then added to materials and labor burden to field payroll. The total is then marked up to a desired gross profit margin.
The method fails because of what happens to direct costs once you calculate and identify them. Jobs A and B have the same direct costs. Assuming that our company field payroll is $15,000 per month, job A consists of one month of payroll while job B consists of four months of payroll. If profit is 10 percent ($12,000) of the 30 percent GPM markup on both jobs, that leaves $24,000 for overhead - the remaining GPM markup.
Both jobs would have $24,000 built into the bid to cover overhead. Using the company’s entire field labor force, job A will last one month. Accordingly, job B will last four months. But the overhead in the four-month job is the same as the one-month job.
THE MARKET-DRIVEN UNIT PRICING METHOD. Do not make the mistake of assuming that there is something inherently wrong with organizing and presenting an estimate in a unit price format. The format is not the issue. The issue is, however, the process - or lack of a process - used to arrive at the unit price. If correctly calculated, unit prices can provide considerable insight into an estimate and plenty of ammunition at the bid table when it’s time to negotiate. For this reason, every time I bid a project, my computer is programmed to simultaneously provide pricing in both a lump sum and a unit price format.
The prices are calculated, however, after all costs for M/L/E/S, general conditions and accurate markups are included in the estimate. These unit prices are then compared to ones normally found on the open market. However, contractors who rely solely upon the market-driven unit pricing method seriously shortcut the estimating and planning process. In turn, they short circuit their business systems. Key information and data needed to direct and control individual jobs, as well as the company and division, is just not available. As a result, meaningful job costing is not possible, and the company lurches forward in a fog.
It’s hard to imagine an estimating method that is less useful in helping to run a company than factoring, but the market-driven unit pricing method is. Factoring, at least, requires that you build upon the foundation of material costs. The MDUP system operates independent of any relevant data, budgets, costs or strategic planning.
THE MULTIPLE OVERHEAD RECOVERY SYSTEM. This method of pricing projects has gained popularity in recent years and is being widely taught in estimating workshops.
This method can have distinct advantages over the previous systems, but it does have definite disadvantages. It is overly complex, and it is difficult to make adjustments for varying market conditions. This becomes a particular liability in periods of rapid market change.
In addition, the MORS method treats all jobs throughout the year as if the mix of materials, labor, equipment and subcontractors were the same as the overall budget and uses traditional markup values that have no clear analytical basis.
The MORS method can and should be firmly grounded upon accurate historic data, current financial statements, well thought out estimating, overhead budgets, projected sales and direct costs for the upcoming budget year.
The first phase of bidding under the MORS method includes costs for materials physically included in the finished product and the labor, equipment and subcontractors’ costs. Material is included at cost. Labor is calculated in field-labor hours multiplied by either a crew average wage or specific wage rates for differing classes of labor. Equipment is included by multiplying hours by the cost per hour for each piece of equipment. Subcontractors are included at cost.
General conditions costs are included for those items required to produce the finished product but that are not directly required to produce the end product. (Lawn & Landscape, March 1998, p. 89)
It must be understood that if you do an inaccurate takeoff, miscalculate labor or equipment production rates, miss other important site conditions or other bidding variables, then the most perfect of estimating systems will be of little help.
Once you have calculated the costs for Phases I and II, add the markups.
- Sales tax is added to materials.
- Labor burden is added to direct labor costs.
- Overhead is calculated.
- Profit is added to the job based on a straight percent markup on the total of all aforementioned costs.
- Finally, a contingency factor is added.
It is with overhead recovery that the MORS method begins to breakdown. Overhead is recovered in a bid by marking up M/L/E/S direct cost totals for Phases I and II by predetermined percentages. Materials costs are usually marked up 10 percent; field equipment costs 25 percent; subcontractor costs five percent.
The cornerstone of the MORS method is the percent that labor combined with labor burden is marked up for overhead recovery. Larger companies, because of benefits enjoyed from economies of scale, generally can use lower markups.
Large commercial companies’ (more than $1.5 million in sales) labor markups usually range from 25 to 45 percent.
Medium-sized companies ($750,00 to $1.5 million) doing commercial and residential work range from 45 to 65 percent.
Smaller companies (less than $750,000) doing commercial and residential work, along with larger (more than $1 million) high-end residential companies, usually range from 65 to 100 percent.
| Job A | Job B | |
| Price | $153,667 | $174,667 |
| (with 10 percent profit) | ||
THE FIELD-LABOR HOUR RECOVERY. Also known as the overhead and profit per hour method, this method provides considerable advantage over all of the previous methods.
It begins by adding tax to materials and adding labor burden to field payroll. It then becomes necessary to have a clearly identified overhead amount on a company or division basis to recover for the year. The overhead amount is divided by the projected number of billable field-labor hours in the company or division to determine the overhead per hour amount.
Overhead is then allocated to projects on the basis of the number of field-labor hours estimated in each bid.
Profit is then calculated in much the same manner as overhead. Contractors do have the choice, however, of marking up the total of the aforementioned costs by a desired percent or by multiplying the number of field-labor hours in the bid by a predetermined profit per hour dollar amount.
There are two critical requisites attached to the OPPH method:
Projected company/division field-labor hours must be reasonably accurate (within 10 percent) for the year.
Overhead must be correctly defined. If you include items in overhead that should be in direct costs, such as field equipment costs and field-labor burden items, you will seriously distort the effectiveness and accuracy of any estimating system.
During the estimating process, you are attempting to identify two numbers. The first is total of your direct costs plus the amount of overhead you need to recover on the job. These two combine to create your breakeven point. The second number is the profit.
Beyond price, a good estimating system produces a plan and a process that will help you run your jobs and company.
How high can you go without losing the project? How low can you go to win the bid without hurting yourself? A good estimating system provides these answers.
The author is a partner with Smith Huston Inc., Orange, Calif. He can be reached at 714/288-1202.
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