By Richard Harshaw
Hidden in your financial statements—particularly your statement of income and expenses (“P&L”)—is gold that most contractors (and no bankers) don’t even know is there. It is in the form of a simple but critical ratio that I call the M:L Ratio.
So what in blazes is an M:L Ratio? It is the ratio of the costs of all materials on a job to the cost of all direct labor on that job. Material is easy to define, of course—furnaces, condensing units, air handlers, heat pumps, humidifiers, UV lights, etc. (For the commercially oriented, substitute chillers, rooftop units, unit heaters, boilers, etc.) The Labor part is a bit trickier—because it assumes that you track the cost of installation labor as a line item on your P&L. The cost of labor would be what you pay your installers and their helpers on an hourly basis (including benefits) for doing an installation.
Here’s an example. Joe runs a shop that does residential and light commercial replacement work. Last year, his P&L showed total material costs of $410,588 while his total cost of direct labor (installers, helpers) came to $137,093. The M:L Ratio says to divide material by labor, so when I do that, I get $410,588 ÷ $137,093 = 2.995. Let’s simplify and call it 3.00.
Great—So You Know Your M:L Ratio. Now What?
Knowing your M:L Ratio can give you a tool to help you decide which jobs to pursue and which to let your hapless competition have, as well as how to bid jobs so that you make your business stronger. (Let’s face it—experience shows that not every job helps you. Sometimes, you get a job that you later wish you had never heard of!)
The concept behind the M:L Ratio is that you make more money when you sell iron than when you sell time. Simple case in point: Two service techs work two days (16 man-hours) and sell $800 worth of parts for a total two-day total of about $8,800 in sales. Two installers work two days (the same 16 man-hours) installing a $76,000 chiller. See the math? And yeah, I know you have a higher margin on service sales, but I have NEVER seen a margin that can offset that chiller job!
Let’s see how this works for deciding whether to pursue a job. Using Joe’s ratio of 3.00, Joe will know the M:L ratio of any job he looks at (whether he bids it or not) before he determines a final price, because he will have done a take-off on that job and know (as best as he can estimate) what the material and labor costs should be. Here’s the key—if the job’s M:L Ratio is higher than your historical ratio (3.00 in this case), that job will strengthen your business. Conversely, if the job’s ratio is lower than your historical ratio, it will weaken your business.
Here’s a real-life example from make-believe Joe. He has been asked by Mr. Snodgrass to bid a heat pump replacement. But Snodgrass’s home is an older one and the old heat pump had performance problems (mostly with airflow) and the new job, to be done right and address those old problems, will take a lot of work and cutting and patching. Joe figures the job’s M:L Ratio and gets a value of 1.72. Should he bid the job?
Not if he has another job with a ratio of 4.08! Why? Because the Snodgrass job will eat up a lot of man-hours to sell a little bit of iron, while the 4.08 job will have a lot more iron attached to the labor hours to do it.
Rule Number One: Use Your M:L Ratio on Every Job Before You Submit a Bid!
But like those old ginsu knife commercials on late-night TV I say, “But wait! There’s more!”
The M:L Ratio can trigger the use of a simple but alternative job pricing method that helps you nail down those high M:L Ratio jobs and lose those awful low M:L Ratio jobs. How can it do that?
By knowing your Overhead to Labor Ratio (O:L Ratio). So let’s keep this straight. You need to know your M:L Ratio to decide if a job will make you stronger or weaker, and you need the O:L Ratio to figure the job price on those juicy high M:L Ratio jobs.
This method DEMANDS that you have departmentalized accounting (taking your P&L for the entire company and breaking it down into sub-P&Ls for each department). I won’t go into how to do that here (I might cover that in a later column if you want to know more—email me through the editor, Lance Lackey at firstname.lastname@example.org. He can then forward your request to me.)
So let’s say that Joe has also run his O:L Ratio for his Installation Department and finds that it is 1.86 (found by dividing $254,993 in Installation overhead by $137,093 in Installation labor).
To get a job price for a rich M:L Ratio job, Joe merely needs to compute the job’s actual overhead, add it to his direct costs (labor and material) and then margin it for profit. Here’s an example.
Joe has a job he is considering bidding on—replacing some rooftop units at a shopping center. He estimates the total material to amount to $78,356 while labor is estimated to run $9,037. The job’s M:L Ratio is a whopping 8.67, almost THREE TIMES his historical ratio. Joe is already drooling!
To get his bid price, Joe takes the labor estimate of $9,037 and multiplies it by his O:L Ratio of 1.86. This gives $16,876 for overhead. Adding his material and labor estimates (based on the job take-off) gives a total cost of $104,305. He wants 10% net profit, so he divides this by 0.90 to get a sale price of $115,894.
How does that compare to the traditional method of dividing all costs by the factor (1 – Gross Margin %)? Joe’s historical gross margin is 38%, so he would divide job costs of $104,305 by (1 – 0.38) which becomes $104,305 ÷ 0.62 = $168,234. That’s a huge difference! Joe would NEVER get that job at that price.
Yet the “ridiculous” price of $115,894 would probably win Joe the job and give him 10% net profit, assuming his take-off is accurate.
An Unfair Tool That Hobbles the Competition
This method also works in reverse, sending ALL the terrible low M:L Ratio jobs to Joe’s competition, forcing them to do low profit work!
Here’s an example, using Joe’s historical M:L Ratio of 3.00 and O:L Ratio of 1.86. He has a complex replacement job to look at (the Snodgrass job). Material will probably come in at $6,500, but labor (which would normally be about $2,150) will probably run about $4,500. Using “traditional” job pricing math, the job total costs of $11,000 would be divided by 0.62 to give a sale price of $17,742. But with his new secret weapon, Joe bids the job like this: $4,500 labor x 1.86 O:L Ratio = $8,370. Add material and labor to get total costs of $19,370. Going for 10% net profit results in a bid of $21,520, almost TWICE the bid of Billy Bob’s Coolin’ Joint! Billy Bob wins the Snodgrass job (and discovers just how nasty high labor jobs can be) while Joe’s crews are free to find and install 2 or 3 low-labor / high-material jobs in that same week.
And notice that the job’s total COSTS are already more than Billy Bob’s sale price.
Do the math. Who wins that scenario?
(The highest M:L Ratio I have ever seen was for a chiller replacement job in Beaumont, Texas with a 21.0 to 1.0 M:L Ratio. The lowest ratios I usually see are for the service department. You can probably figure out why.)
If you are like Joe, YOU win! So figure out your M:L Ratio and O:L Ratio and use them to become the Jedi Master of your galaxy!