A complaint I often hear from my contractor clients after bidding unsuccessfully on a large project: “The winning bid was lower than my costs! The winner must have low-balled it just to get the job”. However, a more likely explanation follows.
Most contractors price a job this way, with minor variations:
- Determine “direct” cost; i.e., those costs directly related to the project.
- Apply a factor to cover the “indirect” costs of running the business (often referred to as “markup” or “gross margin”).
- Multiply the combined costs by a profit factor to arrive at the bid price.
These factors have typically been developed over the years, and have served well for small to medium-sized jobs. However, applying them to a relatively large job almost guarantees being high by 10% or more.
Here is the correct way to price any job:
- Determine “direct” costs as above. Be creative to cut costs. Note risk areas.
- Go into your accounting software P&L statement and identify all indirect costs over the past 12 months.
- Divide the indirect costs by the past 12 month’s gross revenues. This is your past overhead rate. Compare it to the factor you have been using. They should match.
- Estimate the next 12 month revenues, including the “big job”, then divide the past 12 month indirect cost total by the new revenue forecast to arrive at the new OH rate.
- Apply a lower profit margin while considering risk factors. 10% profit on a million dollar job is more than 20% on a $100,000 job.
Here’s an example: My client recently bid a large 4 year Air Force Contract that he estimated at $2 mil. He determined his direct costs to be $1,700,000. He had overhead costs of $140,000 and revenues of $540,000 the past 12 months, so his overhead rate was $140K/$540K = 26 %. Applying the 26% markup to the direct costs, his total costs came to $1,700,000/ 0.74 = $2,297,000. Then applying his “standard” 15% profit, his bid price was $2,703,000. The winning bid was $2,250,000, so my client lost by a whopping $453,000.
Here’s what he should have done: Recalculate overhead rate based on12 month revenue forecast of $1,040,000 (current customer base plus 1st year AFB contract revenues from original $2 mil estimate). His “new” OH rate would be $140,000/$1,040,000 = $13 %. Then, applying a profit of 10 % yields a bid price of $2,183,000, a winner by $67,000!
So the basic lesson is: While your OH costs stay roughly the same with increased revenues, your OH rate will decline. It then follows that by setting a higher revenue goal and using that to apply a lower OH rate, you will be more competitive and see higher actual revenues.