Markup and Profit with Expensive Materials

Should a cabinetmaker apply the same markup to very expensive lumber as he applies to his usual materials? The question kicks off a long and thoughtful discussion of markup, overhead, and profit. March 21, 2012

When marking up labor and materials on a wood manufactured project I'm curious to know how others deal with very expensive material inputs outside of the norm you typically work with. Do you just run the mark up percentage like a typical job or apply some discount or factor that takes in to account capacity?

Forum Responses
(Business and Management Forum)
From contributor S:
Make sure a portion of your markup covers the additional risk you are taking by working with costly materials. Mistakes happen, and when they do you have to pay out of your pocket. Otherwise youíre providing insurance to yourself, free of charge.

From contributor G:
I take the labors hours at cost plus the materials at cost then times two for the selling price. Usually this figure is four times the material cost.

From contributor P:
I think of an estimate as reverse engineering your profit and loss statement. If you want to make 40% gross profit then you need to divide your labor cost and your material cost by .6, do not multiply this number by 1.4 as that will not give you a 40% gross profit.

If you only mark up the material for profit you will not cover your overhead. In other words if the job requires less labor than a typical job and you cover your overhead only on your labor you will end up losing money as your overhead is not covered.

I prefer to markup both material and labor so that your overhead is covered no matter what the relationship of material and labor. This may seem expensive if the material is expensive but it still works with the idea of reverse engineering the profit and loss statement.

From contributor U:
This one is an easy one and always has the same answer for every successful long term business. Selling price equals labor plus materials plus overhead plus profit. If you do anything else with pricing anything, you won't last long.

Each of those components needs to be accurately figured to have a profitable long term business. If you leave anything out or don't estimate your time accurately, you impact your profit. If you don't pay yourself a salary and you work for "profits", then your mistakes come directly out of your pocket. Even woodworkers are not immune from those facts.

From the original questioner:
I have a good handle I think on marking up materials, labor, and overhead. Ocasionally I bid on a job with over the top material costs. Sketch face panels at say $30 a square foot or reclaimed teak lumber at $40 BF. Let me give an example. If I make an alder paneled man door and make a 40% gross profit I just made something like $80 gross using a series of steps and machinery and payroll. If I make the same door from teak the costs and profit dollars might increase 20 fold using the exact same steps, machines, and people. I'm just wondering if I need a new formula or way of thinking when I look at the projects with expensive materials.

From contributor P:
Not by my thinking. If you change the margin the gross profit is going to change. As mentioned before there is also increased risk.

From contributor F:
What happens in the scenario you are describing is you can end up capturing more overhead on a single project depending on your materials costs. You will see a short term profit increase that will be balanced out over a period of time. If the volume is there and the sales dollars are large then you can look at a reduction of overhead but be careful if your metrics are based on a yearís performance. That "additional profit" will be consumed by overhead if you tail off later on. Sometimes what appears to be additional profits dissipate over the course of a year.

From contributor A:
Here's the way I look at it - you gross $80 on the Alder door. If you need to remake it, the $80 goes a long way to at least covering the hard cost of the mistake. You make the same door out of the $40 BF material and price it to make the same $80 gross. If something goes sideways on that door, the $80 that was in it for you isn't even a drop in the bucket.

From contributor F:
Here is the issue I see Contributor A: If you do a $11,000 dollar job with $2,500 in labor, $2,500 in OH on labor, $2,500 in material, $2500 on materials, $1000 in profit, and the customer changes the material to $25,000 you have $2,500 plus $2,500 for labor and $25,000 for material and $25,000 for material overhead. Then you have a $60,500 sell price that flows through the plant in the same amount of time and contributes and additional $22,500 in overhead over a normal project plus $4,500 more profit in the same time period. I think spoilage should be factored into your annual overhead cost. Itís going to happen and you need to be able to pay for it.

Obviously a job with a 25k material would have more relative labor for handling, and higher quality work but theoretically itís the same issue that needs to be addressed and that is do you reduce your overhead billed to the job or not. I think if you want to be competitive in the marketplace you need to at least think about it. On the other hand in my experience higher material jobs with higher wow factors usually have more management time, coordination with other subs and the GC, and more delivery so I deal with those as separate additive line items.

From contributor L:
Expensive materials always add costs besides just the material. As said the risk factor increases and so will labor due to the more careful work rate. Likely the customer will be more picky too. You may also have to assign your most skilled employee who earns more money. If all goes well you should make a better profit.

From contributor N:
I think Contributor U is right on. Materials, labor, overhead, and profit are discreet items that make up the cost of a product. There is very little relationship between these items and attempting to draw relations causes bad bidding, especially in a shop that does a lot of custom work. This is why using material cost based mark-ups is such a bad idea. It assumes that more material cost equals more labor and overhead, that is very wrong.

The argument is often made that more expensive material needs more "markup" (an inaccurate use of the term) because of the "risk". This should already be covered be the normal waste/remake factor. I figure 20% waste on case work, 30% on panel doors and 35% on lumber. I do not assume we will make more mistakes on a more expensive material. In fact we generally are more careful causing us to have less loss. Increasing the labor rate based on expensive material because "the client is likely more picky" assumes your shop is sometimes producing higher quality work than others. This indicates there is another problem in the shop altogether. I can think of a few situations in my shop where I have ordered extra material to cover the fact that the material is very difficult to get, but this was not an arbitrary "markup". I simply ordered an extra quantity of the material to hedge the risk.

Labor and overhead are not supposed to be related. There is a small connection when certain office and management items are considered, but it should not be applicable to job level invoicing or hourly shop rates. Because most shops have full-time employees that are paid regardless of the amount of work scheduled our labor can easily be thought of as overhead; but it is a good practice to keep it separate. Buying a new machine is usually justified by the amount of labor cost it can save. If you do not have numbers on your labor output per dollar it can be hard to make a rational choice.

In my shop I have three different "shop rates" to cover different types of jobs/clients; they are retail, commercial and wholesale. The only cost difference to me is the overhead. There is a lot less overhead on a wholesale job than a retail job. Materials and labor do not vary on these projects only my cost to generate a Job Order. Once the JO is created it behaves the same.

I do occasionally tack on a "high end markup" for special jobs. This has nothing to do with materials and nothing to do with mistakes in the shop, risk of damage to materials, or even my overhead. I am simply adding to my profit margin because I know that I can get away with it. This may seem arbitrary or contrary to my previous statements but it is not. I am treating my profit margin completely separate from the other factors of labor, overhead and materials. I am choosing to add to my profit margin because I know that my price is still competitive on the market. I would not be able to stay competitive if I applied this higher margin to all jobs.

From contributor P:
I will have to disagree, overhead has to do with time anyway you look at it. I can see the point about not assigning as much overhead to material as with the op's situation, but if you only assign the overhead to labor with expensive material there is a better than good chance you will not cover your overhead. If the overhead is not determined by a ratio I don't see how you assign your overhead? Again I look at this as reverse engineering the P&L statement.

From contributor N:
You are pointing out the very thing I was wondering if anyone would stumble on. I never said overhead is not related to time; I said it is not related to labor. In most shops overhead is recovered through the shop hour rate (so is mine). Because we use the same "shop hour" unit of measurement for labor and overhead the two tend to get counted as one, but it is best to keep them separate even if both are accounted for using the shop hour.

Ideally overhead items such as proposal generation, site visits, samples, invoicing and material ordering can be applied at the job level instead of to the shop hour. For example I could calculate that these items cost me an average of $400 per job and add that to the whole job. This would keep the cost tracking more accurate when looking specifically at the job level overhead. It is even possible to do this with electricity and tooling maintenance, but it becomes difficult. Finally it becomes nearly impossible to come up with a rational way to account for rent and insurance at the job level. Therefore these items are prorated over the estimated "shop hours" we will plan for on a monthly basis.

In many cases it is literally impossible to apply overhead items to the job level. In my case I have a published catalog with set prices. I do not have a minimum order so I must try the best I can to accurately compute my overhead on a per shop hour basis. By keeping the labor and overhead separate in my books I can easily look at the number of shop hours I billed last month, how much of that was intended to cover overhead and if it did. The same is true with my labor costs.

I do most of this in QuickBooks by having the "shop hour" being calculated by sub-items (labor, profit and overhead allocation). Because my overhead costs are tracked in QB I can see nice charts showing my revenues in each item and how they match up to my actual costs. It gives a great way to very accurately see if you are charging for everything in proportion. As the sop becomes more efficient and I upgrade machines I can see that my labor portion of the shop hour is starting to far exceed my actual labor costs.

In fact two months ago I literally pulled in several times more than my labor cost, the same happens with the overhead number. This means I have a choice - I can reduce my allocations for labor and overhead in the shop hour rate, or I can increase the profit margin to compensate! The same happens with my material cost/revenue tracking. I do not markup materials and I separately track their costs and the revenue from them. If I see that I am consistently losing money on materials I look for what is causing this. I tend to clear around a 5% profit on materials but this is not intentional, I am only trying to accurately charge for materials. The reason that I sometimes clear a profit is because of items like lumber where my estimated value was higher than the purchase price; hardware and panels are not marked up at all so the revenue and costs cancel out perfectly.

This might all seem complicated but it is a heck of a lot easier than what I used to do. In my quick books I am only billing the client for a few things. I do not use QB for the invoice only for the bookkeeping. Invoicing is done using a relational database that builds pricing on various parameters. All I enter into QB is the jobs shop hours, delivery cost, material cost and a couple other details. All of these numbers come out of the database/Cabinet Vision.

So I agree that overhead is a time related factor and I have a fairly accurate way of separately tracking it from labor even though both are tallied using the shop hour. I do believe it is better to allocate job level overhead to the job as a whole, but for me this would mean a lot more time programming my behemoth of a database, and I would not be able to do it on the catalog sales clients.

From contributor O:
You are selling materials. I go with calculating how much material I need to buy for the job, then a reasonable markup for sourcing, handling, storing, replacing rejects, say 20-25%. This is true for high and low end materials. Other calculations would be the same, adjusted for 'pain in the butt' time with customer or dealing with special materials.

Reviewing your P&L from the past year will tell you if you need to charge more for materials or labor (do your markups give you enough to cover overhead and make a profit)?

Making a profit is often a matter of volume. That customer probably won't accept your rates if you want to work one month a year and want to charge enough to cover a yearís worth of overhead! Silly example, but you do have to produce enough work to make the numbers work. High volume of work with minimal overhead is the way to make money!

From contributor F:
Market pricing should affect two things. First, can you make profitably and sell a product at market price? Second, is there room to raise your price or do you need to lower your net profit margin to gain the sale?