by Richard Harshaw
In my last column, I wrote about an important ratio I call the material to labor ratio (M:L ratio). I defined it as the ratio of material used on jobs to the amount of direct labor used to install that material on jobs. I wrote that it takes a departmentalized income statement to do this calculation correctly, and that the higher the ratio the better.
So What Is Your Average M:L Ratio?
So let us begin with a simple question. What is your material to labor ratio?
I suggest that you take 20 jobs from this year (any 20 will do) and, from the job costing report, jot down the total amount of material (at cost) that you used on that job and the total cost of all of the direct labor on that job. Do this for all 20 jobs. And while you are at it, jot down your net profit percentage on each job as well.
I bet you will find two things that come to light: (1) your M:L ratio is all over the place, and (2) so are your net profits. When I was actively consulting with contractors, one of the first ratios I ran was the M:L ratio. This told me immediately how well the contractor was using his labor to install material. This is vitally important because a contractor stands to make more profit when she sells material then when she sells just time. (And don’t throw up the argument to me, “Well, I make a heck of a lot more profit on service than I do installs!” Of course you do, but 24% of what? $500? Compared to 10% on $8,000 in sales? Don’t get fooled by percentages versus dollars. You put dollars into your bank account, not percentages.)
I have seen M:L ratios on individual jobs as high as 19 to 1 (a straight-out chiller replacement) and as low as 0.75 to 1 (service calls and jobs that go sour).
But here is another dirty little secret: If you graph your data, I bet you will find a rising line as the M:L ratio gets larger compared to profit. Let me insert an example of what I mean.
Here, we see a gradually rising pattern of the dots as the M:L Ratio increases, and since the vertical axis is profit percentage, the data suggests that as the M:L ratio increases, so does the job net profit (as a percentage). Here, I have asked Excel to generate a dashed trend line and a “fit” coefficient (0.6698). This is a pretty good coefficient and suggests a fairly strong linkage between the M:L ratio and profit. (And if we toss out that first job, showing a loss, the coefficient rises above 0.75.)
What if My M:L Ratio is Low?
What is a “low” ratio? There is no correct answer, but the higher the ratio, the better. An M:L ratio of 4.25 is better than 2.79 but weaker than 5.93. How high your ratio is will depend a lot on what kind of work you do most of the time. If you tend to lose by getting lots of labor-intensive jobs that never seem to end and on which you get a bloody nose, your M:L won’t look good. If you win lots of fast-turn jobs—in and out jobs, with lots of iron on them—your M:L will look great.
So what do you do to get your M:L ratio higher than it already is?
First, before you bid ANY job, when the take-off is done and is as accurate as you can make it, run the M:L ratio on the job. If the pre-bid ratio is lower than your historical average, the job will make you weaker. I wouldn’t take the job, but you have to make your own decisions here. (You only have a fixed pool of labor and you don’t want to chase every job in town. You can make a great living on 10% share of market if you know what 90% to leave alone.)
But if the job’s M:L ratio is ABOVE your historical ratio, the job will make you stronger. You should go for it!
But here is where it gets tricky, and let’s see why.
The Devil is in the Bid Details
Most contractors use a single-factor job pricing method (if they use any method at all). The single-factor method (SF) has been around for a long time and is easy to use. It is also poison to your business.
Let’s take an example. Your historical M:L ratio is 1.93. Not bad, but nothing to brag about either. A job comes along you have been asked to bid. Your takeoff shows material costs of $12,587 with labor expected to run $2,056. What is the job’s M:L ratio? 12,587 / 2,056 = 6.12. That is WAY above your historical average so this job will add muscle to your business (and profits).
Now let’s suppose your departmentalized income statement (more on that in a future column) shows that your installation overhead runs 36% of sales and you had 6% net profit last year. Furthermore, suppose the ratio of overhead to labor historically has run 1.42. What happens to the bid?
If we use the SF method, we take the total job costs (assuming material and labor is everything) of $12,587 + $2,056 = $14,643 and divide it by the factor (100% – GM%). Since I only gave you the overhead and historical net profit, we must add the overhead to the desired net profit on the job to get the GM% (here it is 46%, assuming 10% net profit goal). So 100% – 46% = 54%. The divisor must then be 0.58. So dividing $14,643 by 0.54 gives a bid of $27,116.
Let’s now run the bid using overhead as a KNOWN quantity since we know the ratio of overhead to labor. The job costs are now $12,587 for material, $2,056 for labor, and $2,920 for overhead (labor of $2,056 x an overhead to labor ratio of 1.42). Total costs are $17,563. To get 10% profit we divide this by 1 – 0.10 = 0.90 and bid the job at $19,514.
That’s about $7,600 less than the SF bid. With the SF method, you’ll NEVER see high M:L jobs. What will you get? The lousy low M:L jobs.
If you want to get high M:L jobs, you have to run the M:L ratio on every job after doing a good takeoff and using the second method—which I call “COWL” for “Covering Overhead With Labor”—on every bid. COWL helps you win high M:L jobs. It also makes your bid ridiculously high on low M:L jobs. But then, you want those jobs to go your competition anyway! (And if you DO happen to win a low M:L job with COWL pricing, at least you’ll make money on it.)
Try It—But Only If You Dare
So try using COWL on every job bid and see if your M:L ratio does not start to steadily rise. If you have the courage.
Or play it safe and keep bidding with SF—and winning those horrible low M:L jobs. After all, somebody in town must take them!
Enjoy your success. Warning: You may have to pay more income taxes this year because of this. Don’t say I did not warn you!
Until next column, wear your COWL like a good monk.
