Pros & Cons: Volume Based vs. PROOF Type Markups

[JohnNYCT]

So basically I see two markup systems taked about here. The "Traditional Volume Based Markup" and the "PROOF Capcity Based Markup". What do you all feel are the pros and cons for the two?

[Bob Kovacs]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

The main difference between the two, and the advantage of the PROOF system in my opinion, is where you apply your overhead costs.

The key to either system is having a handle on your true overhead costs to begin with. For the sake of this discussion, I'll assume that you already have that under control.

In the traditional system, you have to predict your yearly volume, since all of your markup calculations are based on applying your overhead to that volume. The problem is, especially if you're just starting out, how do you predict that volume? It's important that you predict it accurately because if you fall short toward the end of the year, a portion of your overhead isn't being recovered (the % of OH not being recovered would be the same as the % you missed your volume projection by).

In the PROOF scenario, you apply all of your overhead markup to labor. If it's just you working, it's a simple matter of figuring out how many hours you have available to bill against in a year, and then making sure you work at the required rate for that many hours. It doesn't matter whether you're installing $3/SF ceramic tile or $40/SF marble (or picking up dog poop in people's backyards, for that matter- though I hope it doesn't come to that.....)- as long as you're working and billing for your time, your overhead is covered.

If you have employees, you simply tally up the total hours everyone can work, and distribute the overhead to that total. Then all you have to do is make sure everyone is working again, doing whatever (try to avoid the dog poop scenario, OK?).

That's pretty much it in a nutshell.

Bob

[JohnNYCT]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

As it turns out Bob we happen to use the PROOF type method but I was asking the question I guess for two reasons. One to see if there are any negatives to the PROOF type method and two to see if anyone who uses the volume based method had any good solid reasons for using it. My partner swears that it doesn't make any difference which method you use but since I run the office end of our company I let him bang the nails and I worry about the money.

[Bob Kovacs]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

I can't think of any negatives to it- you're using it yourself- what do you see, if anything?

I also can't see any solid reasons for the "traditional" system, other than the fact that contractors have been conditioned over the years to use it, and they therefore keep doing what they've been doing. Unfortunately, many of them also keep marking up "10 and 10" because that's what they've always done, so I get the intelligence of following that line of thinking just got shot in the foot.....

Bob

[carpenter]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

If my understanding is correct, with the PROOF system you would not mark up materials at all. Is that correct?

If you were using the volume based method and switched to PROOF, wouldn't your labor rate increase substantially?

And what does P R O O F mean?

We obviously are using the volume based method and are new to the concept of using the correct markup. It amazes me that I have hobbled by for so long using the wrong numbers.

[Jerrald Hayes]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

If my understanding is correct, with the PROOF system you would not mark up materials at all. Is that correct?

Well in pure theory that is correct but it's generally accepted practice that you markup materials and subcontracting for what ever you want to earn as Net Profit..

If you were using the volume based method and switched to PROOF, wouldn't your labor rate increase substantially?

Yes that is true since your overhead recovery is then based all on your billable labor. Typically you will see most labor markups in the range of 1.9 to 2.35 for contractors using the PROOF system.

And what does P R O O F mean?

The method is often called PROOF because the name of the management consulting company founded by Irv Chasen who taught so many contractors the method is called PROOF Management Consultants with PROOF being an acronym for Profit Research On Operating Factors. While Mr. Chasen certainly deserves tons of credit for teaching the method (I learned it from one of his seminars) he didn't invent the method. Doing a little bit of research I found the method was around back during the Spanish American War where it was used shipbuilders at the time. In the auto repair industry it's referred to as an Indexed markup. I prefer to refer to it as a Capacity Based Markup since that is a descriptive term about how it actually works ( I also think that is what David Gerstel calls it in his book The Builders Guide to Running a Successful Construction Company (Chapter 5, pgs 167 through 168).

We obviously are using the volume based method and are new to the concept of using the correct markup. It amazes me that I have hobbled by for so long using the wrong numbers.

It's not a matter of one method being correct an the other wrong it really a matter of one method being better than the other under all conditions. Indeed it's entirely possible for a contractor to use a Volume Based markup and not have any problems at all but there are circumstances that arise at times where using a Volume Based markup is either a disadvantage or outright damaging. For the scenario where it is outright damaging you can read my paper The Potential Problem Using a Traditional Volume Based Markup.

The scenario where it's a disadvantage is when clients know the costs of the materials you are using in your projects. They see a door somewhere that costs $1200 and as a Volume Based Markup contractor you are charging them typically anywhere from $1800 to $2004 for that door whereas the Capacity Based Markup contractor will sell them that door for $1320 to $1380. And a Volume Based Markup contractor is at an even further disadvantage if the client wants a $3200 door which will cost them $4800 to $5344 ($1600 to $2144 over cost ) whereas the the Capacity Based Markup contractor will be selling them that door at $3520 to $3680 ($320 to $480 over cost ).

The Volume Based Markup contractor absolutely needs to sell it at the high marked up price to help cover his or her Overhead whereas the Capacity Based Markup contractor doesn't have to worry about that since his or her Overhead has been accounted for and covered by the labor on the door's installation.

[Dave@CCD]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

Jerrald,

"It's not a matter of one method being correct an the other wrong it really a matter of one method being better than the other under all conditions."

This is probably the best philosophical positioning I have seen. Well written sir.

However your ...
"In the traditional system, you have to predict your yearly volume, since all of your markup calculations are based on applying your overhead to that volume. The problem is, especially if you're just starting out, how do you predict that volume? It's important that you predict it accurately because if you fall short toward the end of the year, a portion of your overhead isn't being recovered (the % of OH not being recovered would be the same as the % you missed your volume projection by)....

while correct could also read...

In the PROOF system, you have to predict your yearly BILLABLE volume (hrs), since all of your markup calculations are based on applying your overhead to that BILLABLE volume. The problem is, especially if you're just starting out, how do you predict that BILLABLE volume? It's important that you predict it accurately because if you fall short toward the end of the year, a portion of your overhead isn't being recovered (the % of OH not being recovered would be the same as the % you missed your volume projection by).

Falling short of predicted volume - be it billable hrs or sales - leads to the same end problem - overhead not recovered.

What you do get from the PROOF system is a very solid idea of what it actually costs to operate every hour.

I have found that there are times to price jobs using the PROOF philosophy and other times using the standard volume approach - i.e. it's really a matter of one method being better than the other CONSIDERING all conditions of a given job.

[Allan Edwards]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

When I set pricing on my spec homes, I study the market, my competition, create charts that track pricing, comps, types of homes being sold, location, size etc. I keep an eye on my costs, my anticipated profits. But the market really sets my pricing, I may push it, but in the end, the market sets the value of my product.

When I price my custom homes, there are many factors that influence my pricing: complexity of the house, how demanding the client might be, my current workload, location of house. I know what the top consultants say custom builders should make. I’ve got a pretty good idea, on a national level, what the top builders make, (their profit as a percentage of sales, not markup), I try like heck to be in that group. I have some idea how many of my competitors price their homes. I know what profits I’ve made in the past on custom homes, sometimes embarrassingly low, sometimes unbelievably high and everywhere in-between. I size jobs (and clients) up, and thru part science and part art I arrive at a **number** I want to make for building someone a house. I never think in terms of “markup” and I rarely hear the top consultants mention it.

I don’t differentiate between material and labor, it’s all cost. Cost is cost is cost.

Many people push various types of “markup” systems, and sometimes they work for some because it makes people look at their costs, think about profits, that’s good. It’s really not the system itself, it’s just that previously they had no plan for profitability, now they do. I also think they can become a crutch, and become very limiting.

If you have the ability to sell to at a top level, you should be charging absolutely at the top of what the market will bear, and not get locked into any artificial, formula based method.

[Jerrald Hayes]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

What you do get from the PROOF system is a very solid idea of what it actually costs to operate every hour.

Very true.

Now regarding

In the PROOF system, you have to predict your yearly BILLABLE volume (hrs), since all of your markup calculations are based on applying your overhead to that BILLABLE volume. The problem is, especially if you're just starting out, how do you predict that BILLABLE volume? It's important that you predict it accurately because if you fall short toward the end of the year, a portion of your overhead isn't being recovered (the % of OH not being recovered would be the same as the % you missed your volume projection by).

It can be argued that estimating your yearly BILLABLE volume (hrs) is at least 1/3 easier than estimating your total volume which is going to be Billable Hours plus the Materials you expect to sell plus the Subcontracting you expect to sell too. And two of those things are completely variable based on the whims of your customers. At least in estimating the Billable Hours that you or your company will generate you are talking about a more practically estimable number that you at least have some judgement and control over.

I have found that there are times to price jobs using the PROOF philosophy and other times using the standard volume approach - i.e. it's really a matter of one method being better than the other CONSIDERING all conditions of a given job.

What kind of criteria do you think governs that for you. When I wrote "...one method being better than the other under all conditions." I was thinking that a Capacity Based Markup methodology always works. I can't think of a situation where it wouldn't work.

[Jerrald Hayes]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

...I don’t differentiate between material and labor, it’s all cost. Cost is cost is cost.

Many people push various types of “markup” systems, and sometimes they work for some because it makes people look at their costs, think about profits, that’s good. It’s really not the system itself, it’s just that previously they had no plan for profitability, now they do. I also think they can become a crutch, and become very limiting.

If you have the ability to sell to at a top level, you should be charging absolutely at the top of what the market will bear, and not get locked into any artificial, formula based method.

In it's simplest sense I think "Markup" is the science of after you know your costs understanding what you need to charge for a project to cover your overhead and make a minimal profit. After and only after getting that down should a contractor really begin to think of "what the market will bear". I think a lot of neophyte contractors skip the science of understanding their costs and go right to guessing at "what the market will bear" and more often than not under charge and undersell themselves because they just really want the job.

[David Meiland]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

I think a lot of neophyte contractors skip the science of understanding their costs and go right to guessing at "what the market will bear" and more often than not under charge and undersell themselves because they just really want the job.

Many great points made, but this is the best one and actually the only one that really matters. A contractor who knows what he has to make will either use a volume based approach, a PROOF approach, or something else. If you know your overhead, you do your best to recover it. How you do it really doesn't matter much... you just need to know your overhead.

If you're in a situation where the client gets to see your numbers, then you have to think about how you present them and avoid scaring people. Sometimes that can be tricky.... a good reason to avoid showing people too many numbers.

[Allan Edwards]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

[QUOTE=David Meiland]If you know your overhead, you do your best to recover it. How you do it really doesn't matter much... you just need to know your overhead.QUOTE]


I think Emma Shinn said the one prevailing, common trait she saw in successful contractors was "they new their numbers". Expounding a little, you know your overhead, you know what profit you want to make, you know kind of a bottom line number you need to make on a job. It's not rocket science. I think the most important things is to have a good understanding of your costs (job cost and overhead).

For me, and probably most home builders, overhead is not that big of a number. Overhead, coupled with financing expenses, marketing expenses, and supervision expenses, does become a rather large %, probably in the 20-25% range, that must be made before there is any company profit.

[carpenter]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

Jerrald,

Thanks for your response. You clarified those points for me. Dave is right I think in that it is most important to know what your overhead is, then handle whichever way seems best to each of us. I have for many years used an overhead figure that I got out of an estimating book. The cycle was bid a job, pat myself on the back for including overhead and profit, do the job and get paid, wonder why I was broke. I never had a clue how to calculate overhead until I came to this forum. I now use the Volume Based Method with a more accurate overhead allowance. Our prices did go up and it is easier to cover our expenses. Eureka!

I recently sold a window job where the customer gave me a copy of the quote he got from a supplier I use. When I delivered my quote for the window installed he questioned why the window cost $1000 to install. First, I had switched to a better window and was able to demonstrate the difference. That added about $200 to his cost perception real easy. Second, I explained the cost of doing business, payroll cost and the fact that I am in business to make a profit. His response was to cut out another window, that we also quoted, so that he could afford our service.

The method I used to quote the job and the responses I supplied to his objections are things that I have learned from this forum. I guess my question has turned into a big thank you to all of you guys that so willingly help out.

[carpenter]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

Jerrald,

I just read your white paper on the PROOF system. Thanks for the link. You make a very good case. I think that in the case of our company we will continue with the Volume Based if only because it works so much better than our previous method. I do like the changes that I am seeing and hesitate to alter that for now.

Your paper deals with a good point that has puzzled me. We do have 1 client that we supply labor only for and that accounts for approx. 25% of our volume this year. While our total volume for the year has increased, I wonder about the portion that is labor only. We bill piece work to the customer and have achieved a production level that typically surpasses our billing rate. When we apply the overhead burden to our labor cost we end up with more profit than anticipated without the hassle of purchasing materials. While this looks good, I wonder if there is something I'm missing. Any thoughts?

Thanks again.

[Bob Kovacs]

Re: Pros & Cons: Volume Based vs. PROOF Type Markups

I don't think you're missing anything- as long as you're applying the same markup multiplier to the "labor only" projects as you do to the other work, you're fine. If your typical markup multiplier is say, 1.5, and you're charging out a carpenter who costs you $30/hour at $45/hour, you're fine. You're recovering the portion of overhead thats allocated to that volume of work.

Bob