Understanding Pricing and Break-Even Points

When it comes to setting prices for kitchen and bath remodeling projects there are many factors at work that will influence how it is approached. The one that "trumps" all of the others is market conditions. In this column, we will look at this aspect, how to evaluate the effect of overhead on margin requirements and cost control.

The first issue for review is controlling costs. Assuming that you are in a relatively competitive market, the basic element of your pricing strategy will be your direct cost of doing projects, i.e. materials and labor. Unlike new construction, remodeling tends to be filled with a number of unknowns, and trying to predict and estimate the cost of remodeling projects is anything but an exact science.

The key to estimating the cost of a project is to have a systematic process for producing an estimate and a means of comparing actual costs to this estimate as the project progresses and at its completion. If you are doing more than a couple of projects per year, you should definitely consider employing a computer system for these tasks.

There are several computer estimating software solutions on the market, but most of these seem to be geared more for large, new construction projects or simple cabinet "change out" situations. If you, or someone on your staff, is familiar with computer spreadsheets (such as Microsoft Excel), it is fairly simple to set up a rather sophisticated estimating template that you can then use over and over, and modify each time, as the particular job requires.

Tracking your actual costs is a little more complicated, particularly if you are doing more than one project at a time. Again, there are several computer software accounting systems available that incorporate job costing. If you are used to simply paying from a supplier statement, you will find a job-costing system requires a good deal more up-front effort, coding each invoice as to job and job phase. The return, however, is that you will be able to produce reports that can be compared directly to your original estimate.

The benefit of this detailed information allows you to investigate cost overruns as the job progresses and take appropriate action to bring those costs under control. More importantly, it allows you to adjust and fine-tune your future estimates. The key, of course, is to actually use the information you are generating. Computers have the ability to produce vast numbers of reports and seemingly endless varieties of analysis. The most important aspect is to determine how to identify the exceptions and to focus on them rather than getting bogged down in all of this information.

Overhead and Break-even
Once you have a means of estimating how much direct cost there will be in your projects, you will need to determine how to price them to your customers. But, before we begin this discussion, we will review the difference between "mark-up percentage" and "gross profit margin."

In its simplest form, mark-up is a percentage based on direct cost; for instance, if our direct cost is $1,000 and we mark it up 50%, our sell price would be $1,500. On the other hand, gross profit margin is the gross profit expressed as a percentage of the sell price. In our example, our gross profit would be the difference between the $1,500 sell price and the $1,000 direct cost, or $500, or a gross profit margin of 33.3%. Make sure that anyone in your organization who has anything to do with pricing understands the distinction between these two.

It is your gross margin that will pay for your overhead expenses, so the next step in pricing your projects is to determine what those overhead expenses are. If you already have an accounting system, it should be producing an income statement that will identify expenses such as rent, staff payroll, utilities, etc. These expenditures should include everything you spend money for that is not a direct job cost, plus any depreciation on assets you have purchased, such as vehicles, buildings, etc.

It is important for business owners and managers to know the level of sales needed in order for the gross profit generated to cover all of their overhead costs. This point is referred to as the "break-even point." The basic process of determining a break-even point is to divide the total monthly overhead costs by the assumed gross margin percentage. Again, using our example above, if our monthly overhead expenses are $50,000 and our gross profit percentage is 33.3%, we see that this produces a break-even point of $150,000 per month.

If your sales staff is paid on a straight commission basis, this part of your payroll would be treated as and included with direct costs in performing this break-even calculation. For the purposes of this discussion, we will assume that compensation of sales staff is part of the overhead expense.

The Market
So, in order to keep our math simple, we will cover our $50,000 overhead by selling one job each month with direct cost of $50,000 and marking it up 100% to produce the $50,000 gross profit we need. But, of course, the market forces in your area will probably not allow you to get quite this much of a mark up.
So, how do we determine how much to mark up our kitchen and bath projects?

If you have been in the business for any length of time, you have probably developed a feel for what the market will allow in terms of mark ups and pricing. If you are like most of us, however, you are probably always worried that you will lose a job because your prices are too high.

Let me offer some encouragement. Because of this fear of losing a project, most of us underprice our work by several percentage points. To cover all of your overhead costs as a remodeler (including compensation of salespeople), you need a gross profit margin of between 35% and 45%. This is a mark-up of 154% to 182% on your direct project costs! If you try a few "what if" calculations with your own break-even point, you will see what a dramatic effect raising your gross profit margin even a few points will have on the amount of business you will need to meet your expenses. You will also see how detrimental lowering your margin a couple of points can be when you are tempted to cut prices to "get that big job."

Most projects are not won or lost over price unless you are way out of line, so on your next project, try raising your price by 3% and see if you don't still sign the deal.

Next Article: Managing Field Work