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In the first two articles of this three part series, we learned about markup vs. margins and how to use markup in your financial planning. We conclude our three-part series with the scenario of All That Glitters Is Not Gold. In this situation, you have the opportunity to create a two-year relationship with a general contractor. On the surface, this opportunity looks good, and for many who read it, too good to pass up. However, to be sure a good deal is a good deal,you must do the math.
Let's say we have a medium-sized company that specializes in residential flooring work. Our four man crew is the best and fastest in the area, and we can do most homes in two to three days. We do most of our work for general contractors, and our average price to them is about $9,900. We estimate that we'll do 225 homes this year, and our overhead for the last three years has been 22.5 percent. We consistently make a 9 percent net profit.
The irresistible offer
A new general contractor just arrived in town, and he's getting ready to build some nice homes. We did an estimate for him and came up with the following price to install floors in each of the model she intends to build:
Plan A: $14,655
Plan B: $14,985
Plan C: $15,235
Plan D: $15,470
He's planning to build 144 of these homes in his new subdivision over the next two years. He'll turn and flop the plans, ending up with several different versions of these homes, but basically he's going to build each of the four models an equal number of times.
This contractor has seen our work, and after a bit of negotiating, has made us the following offer:He'll give us an exclusive contract to install floors in all the homes, and he'll guarantee that the homes will be ready at the rate of one every five calendar days. If the homes aren't ready, he'll write us a check for $150 for each day we have to wait before we can start. Who, in their right mind,would pass up that offer?
We've checked his references through a number of different suppliers and other sources, as well as his bank, and he appears to have both the business savvy and the bucks to make this project work. To date, his track record for paying his subs has been good. He looks like our kind of general contractor.
We discovered, however, that at least a third of the subs who have worked with him over the last three years have gone broke. Hmm. Maybe we need to look a bit deeper.
In our last meeting, he "threw in" a couple more requirements that he says he "always asks of the specialty contractors who work on his homes." They are:
1. We must guarantee that the quote we've given him for each of the four models will remain the same throughout the duration of the project (all 144homes).
2. We must give him a 20 percent discount on every fourth home.
Over the last three years, our material prices have been going up an average of 5 percent across the board every six months. Our labor rates have been going up at the same rate. Our labor and materials expense make up 90 percent of our job costs.
The crucial question
Should we sign the contract? (Do your math before you look at the answer provided below. You will gain little if you read the question and the answer without thinking the process through. Show the math to justify your answer.)
There are a number of ways to calculate the math for this problem and arrive at numbers that will indicate whether we should sign on to work with this guy or pass on this opportunity. We can do the math for the entire company, or focus strictly on this project. It's better to stay focused on this project alone. That way, we won't be tempted to make adjustments in the sales price of our other work to compensate for the lack of profit on this project, if it should it turn out that way. However we do the math, you and I should both arrive at the same conclusion, assuming we're in business to make a profit.
First, let's calculate the total volume of work we're considering:
Plan A: $14,655 x 36 = $527,580
Plan B: $14,985 x 36 = $539,460
Plan C: $15,235 x 36 = $548,460
Plan D: $15,470 x 36 = $556,920
Total sales volume = $2,172,420
Our overhead expense for this project would then be $488,795 ($2,172,420x 22.5% = $488,795).
Our 9 percent profit for this project, before deductions, would be $195,518 ($2,172,420 x 9% = $195,518).
Job costs = Sales volume - Overhead Profit, so our job costs would be $1,488,107 ($2,172,420 - $488,795 $195,518).
Our labor and material expenses would be 90 percent of our job costs, or $1,339,296 ($1,488,107 x 90%).
Now, let's look at the requirement that we deduct 20 percent off the price of every fourth floor we install. We know that we'll install floors in an equal number of each of the four models that he's going to build, so we can just divide our total volume by four and deduct 20 percent from that to find our total deduction. (We can assume that the deduction will betaken evenly. A well-written contract will prevent the deduction from being taken off only the higher-priced jobs.)
Total sales: $2,172,420
$2,172,420 Ă· 4 = $543,105
$543,105 x 20% (discount) = $108,621
Total discount = $108,621
We now need to adjust our sales price to reflect the discount:
$2,172,420 - $108,621 = $2,063,799
Adjusted sales price = $2,063,799
Now we must look at the issue of the5 percent increase in material and labor expenses that we're anticipating for every six months we'll be on this job. We can figure that the job will take us approximately two years to complete if we're guaranteed one flooring job every five days.
5 x 144 = 720 days Ă· 365 = 1.97 (or 2years)
Since our labor and materials are 90percent of our job costs, our total labor and material costs will be $1,339,296($1,488,107 x 90%). We can divide that by 4 to get the first six months' expenses:
$1,339,296 Ă· 4 = $334,824
Now we can add the labor and material increase for each six-month period.
1st six months = $334,824 (no increase expected) = $334,824
2nd six months = $334,824 + $16,741(5% x $334,825) = $351,565
3rd six months = $351,565 + $17,578(5% x $351,565) = $369,143
4th six months = $369,143 + $18,457(5% x $369,143) = $387,600
Adding up the four six-month figures,our total is: $1,443,132.
We'll assume that the other 10 percent of our costs, $148,810 ($1,488,107x 10% = $148,810), will remain constant for the duration of the job. Let's add the 10 percent back in to our new labor and materials figure to get our adjusted job cost:
$1,443,132 + $148,811 = $1,591,943
Our adjusted job costs are $1,591,943.
Now we add our adjusted job costs to our overhead and deduct it from our adjusted sales price to determine the profit remaining:
$1,591,943 + $488,795 = $2,080,738
$2,063,799 - $2,080,738 = ($16,939)
We would lose $16,939 of the money needed to pay overhead costs, plus all our projected profit, by guaranteeing the price of this project over the two year period.
A dead deal?
Now we're getting into the philosophy of the business decision-making process. Obviously, we shouldn't take a job knowing we'll lose money. That's a no-brainer. A third of the other contractors who have worked with this guy have done just that, and now they're out of business.
However, this project is guaranteed work for two years. That's always nice—as long as it's profitable. To just say "no" may be a little hasty. Our business is on sound financial footing,and we have other projected sales of $2,227,500 with a 9 percent profit margin. It may be our costs wouldn't go up that much, and we could make a profit. The question immediately arises: Could we ask our suppliers to hold their prices on materials for this job? That would be a reasonable request if they were guaranteed this amount of business over the next two years. Even with no help from our suppliers, we could probably absorb the $16,939 loss and keep on going. That's the up side.
The down side is that an increase in production of this size ($2,227,500 +$2,172,420 = $4,399,920) will also require us to almost double our crew. It'll take time to get the new crew up and working the way we want, and our overhead will go up as we add the new people and expenses generated by the additional volume of work. Looking at this proposal from all angles, it isn't a good move for us under the proposed conditions.
We have options here we need to explore. We can walk away from this job, knowing that the contract as proposed won't be profitable. Or, we can go back to the contractor and negotiate a better deal. Trust me, contractors who know their numbers as well as this guy know—to the penny—what they have to spend on each model.
One approach we could use in negotiations is to say that we'll agree to the contract if he'll allow us to pass along actual material and labor increases during the course of the project, not to exceed 5 percent in any given six month period. In return, we could guarantee him that we'll start all the new floors on schedule, but not require him to pay the $150 late fee on any house that he delays, up to, but not exceeding, five days.
Another option would be to negotiate the 20 percent discount he is asking for down to a number that would make the jobs profitable.
Still another item to consider is the possible increase in production due to our crew doing the same jobs over and over. They will get faster on these houses as time goes on.
As long as we can negotiate a win win contract, we may still get the contract at a price that's profitable for all of us.
The final answer
Yes, we should sign the contract if, and only if, we can negotiate a change in the job requirements that would ensure our business a profit. No, we should not sign the contract if the contractor refuses to change his requirements.
Even though this is a hypothetical problem, it's very close to what could occur in your real business life. You must evaluate every job offer in this way. If you stay in business long enough, a situation like this will arise, and you'll have to deal with it. It's up to you to remember that not all golden opportunities are truly gold.