Gross Margin Versus Labor and Material Markups

Quote of the Day

Most corporate planning is like a ritual rain dance: it has no effect on the weather that follows, but it makes those who engage in it feel that they are in control. Most discussions of the role of models in planning are directed at improving the dancing, not the weather.

— Russell L. Ackoff


Introduction

Figure 1: Bid and Proposal Process.

Figure 1: Bid and Proposal Process.

I have spent a fair portion of my career working as an engineering contractor. In fact, I spent five years working on new business development for a large contract firm. During this time, I was involved in writing dozens of proposals on large projects. A proposal occurs at the end of the bid and proposal process (Figure 1) and constitutes a contract firm's attempt to win the project development contract. It is a key part of new business development for many companies.

In general, a proposal contains a technical portion and a cost portion (sometimes called volumes). While both portions are important, the cost portion is usually the most controversial. The controversy occurs because most proposals are won or lost on cost.

All the companies that I have worked for require projects to make a minimum level of profit, which is usually represented as a percentage of total project price. This profit percentage is known as the gross margin percentage. These companies also have standard markups on their labor and material costs. I assume that the labor markup is always higher than the material markup, which is the most common case.

In this post, I will show that a project's total price must have a minimum labor percentage in order to meet the company's gross margin requirement. Equation 1 calculates the minimum labor percentage required for a project to meet a gross margin requirement.

Eq. 1 \displaystyle {{k}_{{Labor}}}=\frac{1}{{1-\frac{{1+{{k}_{{LMU}}}\cdot \left( {1-\frac{1}{{GM\%}}} \right)}}{{1+{{k}_{{MMU}}}\cdot \left( {1-\frac{1}{{GM\%}}} \right)}}}}

where

  • kLabor is the percentage of project cost in labor.
  • kLMU is the percentage of labor markup.
  • kMMU is the percentage of material markup.
  • GM% is the gross margin percentage.

Background

Definitions

I use these definitions all the time. The key thing to remember is that markups are always expressed relative to costs, and margins are always expressed relative to price.

cost
For this discussion, cost is the sum of all the component costs, assembly/construction costs, and shipping costs.
price
Price is what you charge a customer for a project. Price (P) equals total cost (CT) plus profit (p), which we would symbolically express as P=C_T+p.
markup
Markup is the percentage increase in the raw cost of a component that you charge a customer. Think of it in terms of this formula, P_{Component}=\left(1+k_{MMU}\right)\cdot C_{Component}, where PComponent is the price you charge the customer for the component, and CComponent is your price for the component.
gross margin %
Gross Margin % (GM%) is the profit percentage in your total project price. Think of it in terms of this formula, GM\%=\frac{p}{P}.

Critical Questions

During the bidding process, I always ask questions like:

  • How much money does the customer have?

    Many customers have unrealistic expectations of how much a project will cost. Companies have limited amounts of bid and proposal money and they do not want to squander it on projects that can never happen.

  • How much money does the customer expect to pay?

    A key proposal function is to set expectations – both for the customer and the management of the contract firm. The proposal must educate the project's stakeholders on what performance can be achieved for a given level of investment and risk.

  • What fraction of the project will be material versus labor?

    Most companies have different markups for material and labor. In the case of government contracts, these rates are negotiated. On commercial contracts, these rates may or may not be known to customers. However, all large companies have some form of rate structure.

  • What gross margin do I need to make on the project?

    Companies must generate returns on investment. If the returns are not commensurate with the risks involved, the investment money will go elsewhere and the business will fold.

Analysis

Derivation

Figure 2 shows how to derive Equation 1.

Figure 2: Derivation of Equation 1.

Figure 2: Derivation of Equation 1.

Solution Implications

Maximum Possible Gross Margin

Let's assume that the markup on labor is higher than the markup on material (i.e.k_{LMU}>k_{MMU} ), which is usually the case. This means that I will have the greatest GM% when I have a job that is 100% labor.

In the hardware development business, labor is never 100% of a project's cost. I typically see labor taking up 70% to 85% of a project's cost. However, it is useful to look at the limiting cases because some businesses have projects that are 100% labor (e.g. study contracts). Equation 2 shows how to compute the maximum possible gross margin assuming a given labor markup that is greater than your material markup.

Eq. 2 \displaystyle GM\%_{Max}\triangleq \frac{{P-{{C}_{T}}}}{P}=\frac{{\left( {1+{{k}_{{LMU}}}} \right)\cdot {{C}_{T}}-{{C}_{T}}}}{{\left( {1+{{k}_{{LMU}}}} \right)\cdot {{C}_{T}}}}=1-\frac{1}{{1+{{k}_{{LMU}}}}}=\frac{{{{k}_{{LMU}}}}}{{1+{{k}_{{LMU}}}}}

For example, if my kLMU =25%, my maximum possible gross margin is 50%.

As an aside, the minimum gross margin is set by projects that are all material – a situation that also never occurs in real-life. Equation 3 gives the minimum possible gross margin.

Eq. 3 \displaystyle GM\%_{Min}=\frac{{{{k}_{{MMU}}}}}{{1+{{k}_{{MMU}}}}}

For example, if my kMMU =25%, my minimum possible gross margin is 20%.

Required Labor Percentage Versus Gross Margin

Figure 3 shows the required labor percentage to hit a given gross margin – this chart assumes kMMU =25%. You can see that with a low labor markup, your range of possible gross margin's is limited.

Figure 3: Labor Percentage Versus Gross Margin.

Figure 3: Labor Percentage Versus Gross Margin.

Since all three cases have the same kMMU, you can see that the all have the same minimum gross margin.

Conclusion

I have a number of new grad engineers on my team and this material is part of some training material I put together as part of their onboarding process. It is important that all engineers understand how product pricing affects the overall success of a business. This post provides the basic background these engineers will need to understand how the products they design are priced and why it is so important for them to meet their assigned cost targets.

 
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  1. Pingback: Incorrectly Computed Discount Followed By Markup | Math Encounters Blog

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