By Richard Harshaw
I have some Christmas traditions in my house. For example, yesterday, I set up my “Christmas Movie” stuff—a leg lamp (yes, I have a coveted leg lamp, the fra-gee-lay prize from Italy!), a bobble-head of Ralphie in his pink bunny sleeper, a foam rubber bar of Lifebuoy Soap, and other memorabilia. It is just part of the Christmas scene around my house since that boy and his story in the movie could have been me in the 1950’s.
Along with M&M candies. You know, those special bags of only red and green M&M’s (plain and peanut) that the Mars Candy Company puts out this time of year. (How do those machines sort them so that each bag only contains red and green M&M’s? I’ve never found a yellow one, or blue one in any bag!)
Trivial note: Did you know that M&M’s are made by the two sons of Ethyl Mars, the founder of the famous Ethyl M high-end chocolatier located in Las Vegas? Her two sons wanted to make chocolates that were more affordable for the masses and so came up with the Mars Candy Company.
Now, jumping from the joys of Christmas to a more gruesome concept, we have an expression in America that says we hope there is a special place in hell for people like so-and-so. Where so-and-so is a terrorist, or a certain politician, or a rapist—or, in my case, the clown that invented mark-up. Mr. Mark-up has done more damage to this trade than just about anything else other than government regulators!
Let me begin by starting with my first year in HVAC sales for a medium-sized company in a suburb of Kansas City, MO in the 1970’s. The boss had given me a binder with all of our costs in it and said, “When you get to a job, multiply all these costs by 1.40.” I asked why 1.40? He said, “Because I want to make 40% gross margin on all my jobs.” Not knowing this business yet, it seemed to make sense to me.
So I dutifully marked up everything by 1.40 to get to my sell prices. And my jobs NEVER did produce the 10% profit margin the boss wanted, unless the job was ultra-easy to install and we saved man-hours on it.
But now I know why. A 40% markup does not produce 40% gross margin. It produces only 29% gross margin, some 11% short of what the boss wanted to cover his profit margin of 10%!
Now why is that? It is because of the way accountants report business activity and how contractors mis-use that information to run (or ruin) their businesses.
Hopefully, you get a monthly report from your accountant (either an independent firm or an in-house specialist) called The Income Statement. (Some call it a Profit and Loss, which is a misnomer—it cannot be both a Profit and Loss statement. It is either a statement showing a profit or one showing a loss.) But I will bow to conventional ignorance and call it the P&L for short in this article.
What does the P&L report? It starts by listing your sales (revenues, income). It then lists a bunch of accounts under the heading “Cost of Sales” (or “cost of goods sold”). This would be any expense you incurred because you got a job and ONLY because you got a job. Things like equipment and material, direct labor, permits, fees, inbound freight, warranty exposure, and the like. Subtracting the cost of sales from the income leaves us with—ready for this?—the GROSS MARGIN. (Some yahoos call it gross profit, but we don’t know yet if it is a profit or not—it could be a loss, so calling it a profit at this stage is kind of like wetting a pair of dark pants—it feels good but no-one notices.) Next, the accountant lists a bunch of accounts under a general heading of OVERHEAD. These are the expenses you incur whether you get jobs or not—things like office salaries (and managers), rent, utilities, insurance, vehicles, advertising, and the like. Subtracting the overhead from the gross margin yields the NET MARGIN. (If it is positive, it is a profit; if negative, a loss.) Follow me so far?
So here is the problem. When you work off a cost sheet and elevate that number to a sales price using what you THINK is the right gross margin, you are like a person getting on an elevator of a tall skyscraper on the ground floor and punching 40 to go to the 40th floor. But your accounting documents are based on the SALES of the company—the top floor of the building. By punching 40, you end up on the 29th floor!
Here’s the workaround. The MULTIPLIER you should be using is found by taking the Gross Margin percentage shown on your P&L and subtracting it from 1.00. Then take the reciprocal (“invert it”).
Here’s an example, using my old boss’s numbers. With a 40% gross margin from his P&L (which he later showed me and that’s about where it was), he SHOULD have been multiplying all his costs by 1 divided by 1 – 0.40, or 1 divided by 0.60, which is 1.67. That is 19% MORE than his old 1.40 multiplier. When the boss realized this, his heart sank into his socks and he was very worried. I was too—how could I jack my prices up that much and stay competitive?
But I learned that sales is a learned skill and that it is possible to sell at a higher price if the customer is convinced that your package has the value the higher price demands. (Go see Jim Hinshaw for help on that one, folks! He’s very good at teaching these skills even to clods like me.)
So my advice to you—STOP TALKING MARK-UP. START TALKING MARGIN. And compute it correctly.
For those who are challenged by math and cannot get a calculator to give “2” when you punch in 1 + 1, here is a simple table showing the relationship between margin and markup. Enjoy, and may your margins be merry and bright!
Gross Margin (from P&L) Markup to Use