Accurately pricing your work depends on your knowing some key terms, including overhead, production costs, gross profit, target margin, and labor burden. I’ve discussed these terms in detail in our recent Pricing the Job series:
• Price the Job Right, Starting with Overhead
• Profit is Not a Happy Accident
• Markup and Margin
To better understand the “math” related to these terms, I've compiled this quick visual guide. If you get these formulas down cold, and constantly use them to analyze your numbers, you’ll have a much greater chance of pricing jobs to make a profit.
To make it easier to understand, I’ve created a visual representation of how these terms relate. Let’s consider the total dollars coming in as a result of sales as a lump amount represented by an undivided pie chart.
When considering INCOME, remember that the total dollars coming in will be distributed to one of three places:
• Production costs (COGS)
So the pie will be the same size as the income pie, but divided into three slices.
Because we know that if you want to count on getting profit, it’s wise to consider it just another overhead cost, we can combine Overhead and Profit, so now that same size pie has only two slices.
And because we also know that gross profit will always equal the sum of Overhead and Profit, we can rename Overhead and Profit as Gross Profit.
So now let’s just add some letters to identify the pie and slices: Let’s call Income “A,” COGS” B,” and Gross Profit “C.”
Using only addition and subtraction, it’s easy to see that:
Income – Gross Profit = Production Costs
Production Costs + Gross Profit = Income
When you start relating the pie and slices using division (required when you express one thing as a percentage of something else), markup and margin emerge.
You can use this relation to understand total Income as a function of Gross Margin and Gross Profit.
… and to understand your Production costs as a function of Markup and Gross Profit.