profitability

Pricing in a Job Shop: Setting the Shop Rate

by Tom Gray | on Mar 28, 2012 |  Comments

A “job shop” sells custom-made parts, produced according to customer specifications, usually in small quantities. Job shops develop a price quote for each job, rather than establishing a standard list price per product.

Their “shop rate” is a bundled price applied to billable labor hours (those spent on the job being quoted), designed to capture enough revenue to cover labor costs, overhead, and target profit. Setting the right “shop rate” is the key to their profitability.

This article provides the techniques for calculating a shop rate. For example, employees may earn $25/hour, but the company may need to charge its customers $75 to $100 per hour spent on a job, to recover overhead and profit as well as labor costs.

Step One: Estimate Costs and Target Profit

First, estimate the costs to be recovered by the shop rate for the coming year. For our example, we assume the following costs are passed through to the customer without markup: materials, subcontractors, shipping. This means the shop rate must recover labor, overhead, profit, and sales commissions.

Labor includes hourly wages (whether or not they are billable on jobs) plus benefits and related payroll taxes. Overhead includes the owner’s salary, benefits, and payroll taxes, plus fixed costs such as rent, utilities, insurance, maintenance, computers, vehicles, depreciation on equipment, etc.

Profit will be a dollar amount, not a % of revenue at this point, because revenue is unknown. Assume the profit target is an amount equal to the owner’s salary.

Sales commissions might normally be 5% of revenue, but we do not know revenue yet. Use one-sixth of salary plus overhead (excluding labor) as an estimate, based on the assumption that salary plus overhead will turn out to be 30% of revenue.

For this example, assume the following: owner’s salary is 50K; other overhead aside from labor is 100K; profit is 50K; sales commission is 25K; non-billable labor cost is 80K and billable labor cost is 120K. This assumes 60% of paid labor time is billable on jobs. The rest is setup/cleanup, training, paid time off, and miscellaneous. Thus the shop rate must recover 425K.

Step Two: Estimate Annual Billable Hours and Calculate the Shop Rate

Second, estimate the number of billable hours for the year. Billable labor cost of 120K less 10% payroll tax and 10% benefits leaves approximately 100K. Divide that by $25/hour to get 4000 billable hours.

The resulting shop rate is 425K / 4000 hours or $106.25 per hour. This is an illustration, not a recommended price! Your shop rate depends on your own numbers: overhead, salary, profit, wage rate, etc. However, note that it is not unusual for the shop rate to be 3 or 4 times the hourly wage rate.

Avoid Two Common Errors

One common error in calculating the shop rate is omitting the target profit. Another is assuming all paid labor hours are also billable hours.

Job shop owners should review their shop rate at least annually. The tip about small changes having big results (see Pricing Tips: Start High; Big Results from Small Changes) applies here as well: raising your shop rate by $2 may increase your profits by 20%. Use your own numbers, and check it out!

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com.

 

Owning Your Own Business Means Owning Your Own Books

by Tom Gray | on Jan 05, 2012 |  Comments

Most small business owners don’t understand bookkeeping, Quickbooks, contribution margin, or cash planning, so they shy away from learning how to use their results to improve the business.

Yet when small businesses fail, it’s because they run out of cash. Why does this happen, and why do owners allow cash shortages to develop in the first place? Too often, it’s because they don’t try to understand their numbers.

They assign someone else to “keep track” of the numbers.  Unfortunately, bookkeepers are not planners. Bookkeepers look backward, not forward. Owners are the only ones whose job includes using past performance to improve future results, but they usually do not know how.

The owner is the expert on what the business does, spending up to 80 hours per week to make sure the business has effective operations, and maybe even spending some time on getting new customers. Small business owners typically do not make it a priority to understand their numbers well enough to predict their future. Short term demands make future planning seem like a low priority. Then they run out of cash!

Fortunately, it is not difficult for small business owners to understand their numbers well enough to plan, even without learning software (e.g., Quickbooks) or bookkeeping. Three techniques are all they need.

  • First, require the bookkeeper to export the monthly Quickbooks Profit and Loss Report to an Excel spreadsheet with one column for each month of the year.
  • Second, have the bookkeeper reformat the data in Excel into an Income Statement with a reasonable number of revenue and expense categories (see below), and for each category heading show the “% of Revenue” in that line.
  • Third, study where the money goes and create ideas to change those percentages.

Let’s look a little deeper at each of these techniques. First, the Internet has dozens of entries telling the bookkeeper how to export data from Quickbooks to Excel.

Making Quickbooks Reports Manageable

In the second task, you are making the Quickbooks data more useful by reducing the number of entries to a manageable number. For revenue, you should have a summary line for each product type. Even in a job shop, you can categorize your jobs into types.

The next main category is variable expenses, or Cost of Goods Sold (COGS). Your lines for variable costs will be labor (and associated payroll tax and possibly benefit costs), materials, subcontractors, shipping, and sales commissions. The labor line will include labor costs devoted to production, with nonproductive labor hours shown elsewhere as overhead costs.

The last major category is fixed or overhead expenses, those that stay the same regardless of production volume. Here is where you will invent headings and summary lines to group costs by type, so the number of lines is manageable. Ten categories should be sufficient. For example,

  • Nonproductive labor/tax/benefits
  • Salary/tax/benefits
  • Facility costs (rent, maintenance, utilities)
  • Computer costs (hardware, software, maintenance)
  • Vehicle costs
  • Office expenses (include phone and bank charges)
  • Professional services (accountant, legal, consultants)
  • Marketing costs (include travel and entertainment)
  • Dues and Licenses (professional licenses, conferences, dues and subscriptions)
  • Miscellaneous – but try to keep this minimal!

This is a lot easier to work with than 30 or 40 accounts, most of which say 0 for the month! If it is easier to work with, there is a better chance you actually will work on it!

Analyzing the Results

The third technique is analyzing the results. This is the owner’s job, and no one else’s. Up to this point you have simply been telling the bookkeeper to present the data in a more useful way

Analysis starts by looking at % of revenue for each line. The key line is “contribution” (to cover overhead and provide profit), also called gross margin. This is revenue minus variable costs, or revenue minus COGS to some accountants.

Hopefully this margin is at least 50% of revenue. Why? This margin is what you have left after building the product, and its job is to pay for overhead and leave a profit. If your margin is 50%, and your overhead is 30% of revenue, then your pre-tax profit is 20% — a good number.

Numbers are the way we keep score. Without them, you can’t know if you are winning the game or losing, until it is too late! Small business owners can avoid a cash shortage without expertise in bookkeeping. The secret is to present their results in a way that enables planning, using percentage of revenue and contribution margin. In the next article, we will discuss how you can use this data to improve your business.

Does this seem do-able so far? Does it seem worth doing?

Tom Gray helps owners save and grow their companies. He is a management consultant focused on small business and telecom, a Certified Turnaround Professional (CTP), a Certified Business Development Advisor, and a Certified SCORE Mentor. He can be reached at 630-512-0406 or tgray@tom-gray.com. See www.tom-gray.com