Creating a Price Formula System for Your Business

If inadequate budgeting is the first planning mistake that most kitchen and bath dealers make, then faulty pricing of their products and services must be a close second. What most dealers don’t realize is the logical connection between the budgeting process and a price formula system. Indeed, the purpose of a price formula system is to collect the gross profit dollars established in the budget.

As the most important byproduct of the budgeting process, the price formula system for a kitchen and bath firm should consist of three parts: (1) calculation of the production overhead (burden) rate, (2) calculation of the respective markups for each business mix category, and (3) establishment of a service contingency percentage.

Burden Rate Calculation
The labor used to install a kitchen is commonly referred to as a direct labor expense and can be easily posted to a specific job. However, there are many indirect labor expenses that are more difficult to identify and cost to a specific project, such as: project manager’s salary, truck driver’s salary, truck expense, warehousing, workman’s compensation insurance, health insurance, retirement, payroll taxes, etc.

How can these indirect costs of production be properly job-costed before paying the sales designers’ percentage share of the gross profit? To do otherwise would be to overpay the sales designers and under-collect for the firm’s overhead. The answer lies in the (a) development of a production overhead schedule during the overall budgeting process and (b) the creation of a “burden rate” to collect these indirect costs of production.

Using a $1,500,000 model operation as an example, here’s how to develop the burden rate:
1. Subtract highly competitive cost items from the total cost of sales. Appliances would be a good example. Let’s assume the budget for the firm’s $1,500,000 operation calls for $150,000 in appliance revenue at a 25% gross profit:
Total Income = $1,500,000 100.0%
Less Budgeted
Gross Profit = - 615,000 41.0%
Total Cost
of Sales = $885,000 59.0%
Less Appliance
Cost of Sales -112,500
Sub-Total Cost
of Sales = $772,500

2. Subtract the total production overhead budget from the sub-total cost of sales. Assume the production overhead for this $1,500,000 operation is $70,000.
Sub-Total Cost of Sales = $772,500
Less Production Overhead = -70,000
Net Cost of Sales = $702,500

3. Divide the budgeted production overhead by the net cost of sales. Then round up for error.
Production Overhead = $70,000 = 9.96%
(round to 10%) Net Cost of Sales $702,500

For this hypothetical operation, a burden rate of 10% should be added to the cost of sales (including costs of material, use tax, direct labor and subcontractors), exclusive of appliances. You can check the accuracy of your burden rate quarterly and make adjustments up or down, if necessary.

Markup Calculation
The markup is intended to finance the collection of the sales and 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 (over the burden rate) based upon your expected business mix. Using the hypothetical $1,500,000 operation again, a pricing strategy chart depicting the necessary minimum markups for four different market categories is shown in Table 1.

The imperfect nature of the business requires there be an allowance for gross profit slippage. So the minimum markup for kitchen remodeling projects is set at 1.79 or 44.1%, 1.1% higher than the desired 43% gross profit. Because bathrooms are more difficult to produce, there is nearly a 2% slippage built into the 1.92 minimum markup.

It is also suggested that owners give pricing flexibility to their sales designers. For example, the range for the kitchen remodel category might be a minimum markup of 1.79 to a suggested markup of 1.85. If compensation is based upon a percentage of the gross profit of the job, good sales designers will always seek to achieve the highest markup, particularly if they sense the client will need a lot of hand-holding through both the design and installation stages.

Service Contingency
The third and final component of an effective pricing system relates to the costs incurred servicing a job within the typical one-year warranty. Let’s say 10 months from the close of a job, a subcontractor sends you a $105 invoice for adjusting doors and roll outs on the Smith job. 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. Rather, it should be posted 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, exclusive of the appliance selling price. Note that any gross profit dollars generated through this price formula component should not be shared with the sales designer.

Pricing Model
Putting these three components together, an example of what the overall pricing model should look like is shown in Table 2.

As compensation, note that the sales designer shares in the $21,725 gross profit. That percentage share depends upon (a) the salesperson’s job description and (b) whether they have a base salary + commission, draw against commission, or straight commission plan.

As you can see, I believe there needs to be singular pricing methodology (per market category) to be certain of collecting the necessary gross profit dollars to finance a firm’s production burden, direct overhead and desired net profit. Many dealers tell me they need different markups for different material categories – such as 1.60 for cabinets, 1.40 for granite countertops, 1.30 for labor, etc. – and these numbers are what they are able to get in their local trading area. To do so has little correlation, if any, to the realities of running a business from a financial management standpoint.

However, after you have arrived at the correct, singular selling price for a job based upon your budget, you can still unbundle the numbers any way you would like. That’s a marketing strategy known as a “shock-proof” price presentation.