Calculating Markup

Last week we discussed adjusting your markup based on the length of a job. In the example used, the writer estimated job costs using a $64/hour labor rate. That $64/hour would be either their fully burdened labor rate or their charge rate; I doubt it’s the actual rate paid to employees.

It reminded me of a question we received last summer that we haven’t addressed yet:

In regards to employee labor rates when doing estimates. Are you figuring the labor rate based on what the actual employee burden cost is and then x your markup? Or are you using a labor rate that is industry standard x your markup? In other words, if my total employee burden cost is $26 hr, would it look like $26 hr x 4 hrs = $104 x 1.5 markup? Or using the same $26 hr rate would you use the standard here of $30 – $40 hr x 4 hrs x markup? As you can see, the results can be $1,000’s different on a job depending on which way you figure it.

The answer: it depends on what you assumed when you calculated your markup. Using the wrong labor rate, or using someone else’s markup when you don’t know their assumptions, is one of the biggest mistakes we see and, as the question points out, the difference can be thousands of dollars.

A few definitions:

  • A fully burdened labor rate is your full cost of an hour’s worth of work. It includes all payroll taxes and any other costs related to labor. Vacation pay, health insurance, and any other benefits or expenses related to employment are included.
  • A charge rate is used in Time and Material contracts. It would include all labor-related costs just like the fully burdened labor rate, but it normally also includes a chunk for other overhead expenses and often profit.

That’s a quick and dirty definition of the different labor rates; an accountant would go into more detail, but you get the idea.

Here’s the issue. When you calculate your markup, you start with last year’s P&L and adjust your overhead to estimate what you’ll need next year.

If you keep all labor-related expenses in your overhead when you calculate your markup and then estimate jobs using a fully burdened labor rate, you’re adding overhead to your sales price twice; once in your labor rate, again in your markup. If you estimate jobs using a charge rate, it’s even more extreme. Your price will be much higher than it needs to be because you’re recovering overhead and maybe even some profit in both your job costs and in your markup.

This mistake can also go the other way: if you deduct labor-related expenses from your overhead when you calculate your markup, then estimate your jobs using a $15/hour rate because that’s what you pay employees, you’re underpricing and losing money.

So, when you quote a job, you can use the rate you pay your employees, or your fully burdened labor rate, or your charge rate. The rate you should use depends on what you included in overhead when you calculated your markup.

There isn’t a right or wrong way to do this, it really doesn’t matter. What matters is that you’re consistent; whatever assumptions you make when calculating your markup need to be considered when estimating your job costs. The goal is to have all your payroll taxes and benefits accounted for when you quote the job, but only once. If you aren’t consistent, you’re doing it wrong.

It’s dangerous to compare your markup to someone else’s, because you don’t know their assumptions. If they have a markup of 1.5 and estimate labor at $50/hour, and you use their markup while estimating labor at $15/hour, you’re probably headed for trouble.

When I say that the markup for a typical remodeling company is usually at least 1.50, I’m assuming a fully burdened labor rate. If you estimate jobs using the actual rate paid to employees, you’ll probably need a higher markup. You need to calculate your numbers based on your situation. If you don’t know how to calculate your markup, it’s one of many things covered in our book, Markup and Profit Revisited.

One more thing. If you’re doing time and material work and use a charge rate for invoices, don’t use someone else’s charge rate, or try to track down the going rate for your town. That’s the same as using someone else’s markup; it can get you in trouble. There is no industry standard. You need to look at your labor expenses and your overhead and profit needs, then calculate your own charge rate.

We’ve talked about markup for two weeks in a row. Next week, I promise, there won’t be any math.

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