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Can a Discount Increase Profits?

Posted by David Thiemecke on 1/10/17 6:06 PM

If you ask a technician who is just starting out to estimate the cost of a job, they will definitely take into account labor (the work they have to do) and probably materials. The tech might even include a markup for profit. Since you have to cover all the bills, not just the jobs, you know that there’s a lot more to pricing a job.  Your everyday prices should reflect the value to a homeowner, but a homeowner isn't much different than that tech and will think about your invoice the same way the tech does. If they are debating the cost of a work order, will they use the same logic to question your pricing? If they do, do you consider a discount? A discount might win a good extra job, but how much can you afford to drop the price? Deal of the Day 

What's the price of your very first job?

Auto Assembly LineA mentor game me this example a decade ago:

If you just built a $1-billion manufacturing plant, what would you price the first car coming off the assembly line?

Is it really $1-billion? Clearly, no one will pay $1-billion for a Ford F150. How many F150’s do you have to sell before you’ve paid for the plant? A better way to get an answer is to spread the cost of the plant over the expected production for a year (or five, what’s the plant lifetime?!) That’s a reasonable number of trucks so the price is competitive, you’ll cover the cost to stay in business, and make your gravy on the trucks built after that payback. Looking another way, a portion of the truck price goes to the stuff you need just to make any truck, no matter how many.

Variable, Fixed, Direct, and Overhead Costs

Fixed, Variable, and Total Cost GraphLet’s come back to contracting. There’s a couple of concepts to unpack. First, in every estimate you have some variable and some fixed costs. Time worked, yards used, quantity sold, or some other measure drives variable costs. You can tie your labor and materials to a job, so those are called direct costs.

Fixed costs stay the same no matter how many jobs you do, like office and shop rent. You pay these just to stay in business. The fixed stuff like rent, utilities, bookkeeping, taxes, sales base salary, and training are among your overhead costs. This is stuff you should distribute over your jobs.

Trick question: where does customer service fall? Your head of customer service might be a fixed cost, but you could consider her assistant rep a variable cost because you hired her to take on customer growth.

What’s an easy way to cover your overhead? 

  1. Add up all the overhead costs for a year. 
  2. Divide that by 12 to get the amount allocated to each month. 
  3. How many hours do you realize in a month on average? 
  4. Divide the overhead cost by your realized hours. Now you know how much overhead cost to tack-on for every hour billed. 
  5. When you cost a job, multiply the billable hours by the overhead unit cost. This is the amount that this job must to contribute to overhead that month. 

You can also peg overhead to another variable. I chose realized hours since it burdens small jobs differently from big ones. I’ll talk another time about new hires, departing staff, step costs, and lumpy payments that are due a handful of times per year since they affect your cashflow. Questioning the drivers of your direct costs and allocating overhead is also like activity-based costing.

What happens if you met your overhead goal for a month?

Let’s get back on track toward discounts. You worked enough jobs and realized enough billable hours to pay for that month’s rent and your other overhead expenses. Every job you work  after that no longer needs to contribute to overhead. If you left your pricing the same, it's just extra profit until the month rolls over. Could you pack in more jobs at a lower price and still increase your profit? Yes, but what's an alternative?

You could allocate your month’s overhead to fewer jobs, but that drives up prices and may make you uncompetitive. There’s pressure to keep prices lower by distributing overhead over as many jobs as possible. Still, you have a number of realized hours your team finishes before month-end. How low could your price go on extra jobs after that?

The answer is that you can go as low as your direct costs plus your desired profit. On jobs you take after covering overhead for the month, you’re free to stop contributing to overhead. It’s as though you set rates based on the cost to produce one additional job — your marginal rate. At the start of a month, your marginal rate is high because you must contribute to overhead. Later, you meet your monthly nut and your marginal rate drops, provided it’s a job that fits.

Which jobs are a good fit?

This is a big deal. Be selective. You want:

  • High confidence you’ll reach your overhead nut before starting the job.
  • A job that doesn't displace higher paying work that didn’t need a discount.
  • A job for customers who understand that they’re getting a one-time deal, like rewarding loyalty or asking new customers to "give you a try."
  • A quick decision from the customer, before the deal expires.
  • Simple, straightforward jobs that get done on-time, in-budget reliably.

Even if you have to cover overtime to take the extra job, that’s still a direct cost. Don’t miss it. If you were a factory producing a product, you might not be able to change prices to cover overtime — so you’d avoid overtime like the plague. Since you’re a contractor, you have more flexibility to adjust pricing on extra jobs (at the risk of staff burnout). Your overtime direct cost plus profit may be lower than your fully-loaded contribution to overhead, so it's still a discount! Just don't do a job costed at regular time during overtime.

By the way, year-long maintenance agreements are great for packing your schedule with committed work that pays your overhead. It’s like you get to extra jobs sooner in the month. Don’t discount predictable/repeatable work, since it should build your base.

Pitfalls

Some jobs make a bad fit for discounts too. Spot them early.

Big Bear Trap - You can always say no to offering a discount.

  • The really big job can be dangerous. If you're late to finish then it may consume time that must contribute to overhead.
  • Delays or jobs that last into the next month (overhead period)
  • Damages or call-backs: at a discounted price you’ll lose money faster
  • Customers may start expecting your discounts and withhold their orders until you offer discounts, cannibalizing your base revenue.
  • You can promote a discount, but only with an expiration so no one claims it when it hurts you.
  • Your overhead goal changes and you didn’t adjust for it (e.g. your rent went up).
  • Someone on staff offered this price too long, too low, or to the wrong jobs. 

You'll need a tool to keep track of the proposals offered and discounts claimed, and Field Nimble makes a great fit. I've made all the mistakes I mentioned here in some of my other businesses. I hope this helps you!




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