When it comes to running your kitchen and bath firm, one of the most important things you need to do is calculate pricing in a way that ensures your projects will be profitable. There are two primary ways to approach project pricing: Cost Plus (where you negotiate specific markups with a client for work to be done) and Fixed Price (where the price of the project is set, subject to changes to project scope). In either case, it’s necessary to generate a certain amount of gross profit or margin to cover your firm’s general overhead and operating expenses.
This month, we’ll start with a discussion of how to divide up your costs between fixed costs and variable costs.
Fixed or Variable
Any discussion of fixed and variable costs must begin by acknowledging that there are few totally fixed or totally variable costs. Rather, we define a fixed cost as one that will remain the same month to month over the short to medium term. Examples of such fixed costs would be building rent, utility bills and office staff. Variable costs are generally those that are associated with production of a company’s product – in our case, a remodeling project. Such costs include job labor, job materials and subcontractor costs.
Although selling expenses and commissions are often seen as part of the office staff costs, they are usually variable costs, since most salespeople are paid a commission based on a percentage of the sales price of our projects. Once we have identified our fixed costs, we can perform some calculations to determine what sales volume we will need to cover these. This is referred to as a “break-even” point: the amount of sales required to just cover fixed costs.
Mark-up and Margin
When product is sold, the first element to identify is the direct cost of the product. If we sell one more item of a particular product, what is the cost of acquiring that product? In most instances, this will consist of the price we pay our supplier, plus the cost of having the product shipped to us. The difference between this cost and the price we charge our customer for the product is our gross profit, or gross margin. If our cost of a product is $100 and we sell it for $150, there is a $50 gross margin.
Let’s pause here to make sure that we clarify the difference between mark-up and margin. We can look at our example below to help us clarify the difference between the two:
Mark-up, on the other hand, is an expression of the relationship of sell price to the cost we have paid for a product. In this case, we would use a mark-up of 50% on our $100 cost to determine a sell price of $150. The danger comes if someone setting pricing knows that the company guideline is to maintain a 33% gross profit and then marks up cost by 33% instead of 50%.
Calculating Your Break-even Point
Let’s begin by creating an example of a medium-size remodeling business.
Now that we have identified our fixed costs, it’s possible to determine what our total sales volume must be at various assumed margins (gross profit percentages) to just break even. Several factors will go into coming up with the necessary gross profit percentage. The competition will influence the prices you are able to charge, along with the law of supply and demand, and that means you can likely sell more at a lower price. Remember, too, that the margin (gross profit) must cover your sales commissions.
If we assume a gross profit percentage of 45%, we can determine the break-even point by dividing the fixed cost total by 0.45. So we can see that sales of $1,533,333 would yield $690,000 of gross profit. Likewise, the markup required on our costs to achieve a 45% gross profit can be calculated using the formula: 1 / (1-.45) = 1.81818.
Using this information we can do some “what if” scenarios to see what happens when you feel that a price reduction is necessary to beat the competition or help sell that really big job. If we reduce our sales price by 10%, it reduces our gross profit from 45% to 35% and will raise our break-even point over $400,000 to $1,971,428. If you’re convinced that lowering prices will generate enough additional volume to produce the required gross profit, then it might be worth considering. Keep in mind, however, that this increased volume may cause some of your “fixed” costs to creep up, i.e. more office help, additional equipment, etc.
Understanding the relationship between mark-up, margin, overhead and break-even will allow you to manage your selling strategy in order to maximize profit. Too often, the focus within a business is on the raw sales volume that the business is doing instead of the profitability such sales produce.
Keep in mind that a big part of what we are selling is our unique design abilities and the expertise our firm can bring to a customer’s project. The cost of a project is therefore much less price sensitive to our customer than if they were buying a product such as a refrigerator, where they could make an apples-to-apples comparison of prices.
We cannot ignore the necessity of controlling overhead costs. While we may have a good deal of leeway in pricing, containing our costs will increase our bottom line profit and allow us to increase margins without having to raise prices. We should not ignore the fact that there are competitors who will work hard at controlling their cost of doing business.
One consideration that does not lend itself to a calculation is just how large an organization you want your company to become. More sales volume will normally generate more gross profit, but it will also lead to more employees, more equipment and separation of duties and responsibilities. In developing your sales and pricing strategy, you need to consider how large and complex an organization you want to have.
Make sure that everyone within your business understands the relationship between pricing and cost. In most of our businesses, nearly everyone will be involved at some level in setting the pricing on contracts, products or change orders. You don’t want them using your company’s target margin percentage as the mark-up when they price these.