The Trouble With Time-and-Materials

There are many reasons to use a certain pricing system - some are convenient, some safe, some capitalistis and some lazy.

December 31, 2003

 

Alan Hanbury

There are many reasons to use a certain pricing system - some convenient, some safe, some capitalistic and some lazy. Some contractors make money with time-and-materials, or cost-plus, or whatever name you choose. Their companies invariably have lots of full-time office people, copying machines, higher-than-average volume and untested estimating or specifying skills.

Of course, fixed-price contractors use T&M when there are walls to tear open, rotten sills to contend with, or a large change order that needs to be expedited without a full-blown feasibility study, pricing and mini-contract.

Nevertheless, I don't understand how or why you run an entire company on T&M. I am driven by profitability, and only one system allows you to maximize profit with the least amount of administrative time, paperwork, volume and staffing - all while giving the customer the peace of mind of a fixed price for the project.

Very bad things

  • T&M doesn't force a client to make good decisions early. Loose ends always cost more later. It doesn't allow for factory orders or looking for sale prices and deals by the client or the contractor, and the project always ends up taking longer.
  • When you have no project "price" to put on an application, there is no way to budget with the bank, your savings or any other money source.
  • T&M does eliminate some risk, and it doesn't have a "cost" that your clients can compare with other bids. That doesn't mean you don't have price competition. On the contrary, hanging out your "pricing model" (markup and dollars/hour) for everyone to see, receipt by receipt, places all of the emphasis on price.
  • Clients demand better timecards, materials sheets and documentation of meetings, scheduling and other off-site time added to contracts. Companies must radically change paperwork administration or boost staffing (in a tight market!).
  • T&M does not allow for job-cost variance reporting, so you might never know which employee is the best framer, trimmer, lead carpenter, etc., because there are no performance benchmarks.
  • In fixed-price, you could push aggressively for and/or price fixed-price change orders at higher margins to get a job back on financial track. Fixed-price change orders can become a job-saving (i.e., lifesaving) profit center.
  • With no final price, payment can be a problem. Fixing punchlist or aesthetic items is more likely to be used as a bargaining chip, and clients might refuse to pay. It's hard to sue or even arbitrate with no agreed-upon price. Homeowners can bring in their own materials or subcontractors. You can do little about this, especially for work outside the original scope.

Where's the profit?

With T&M jobs, I have heard of a few hardy souls who ask for as much as 30% markup on subs and materials. Most ask for 10% overhead and 10% profit or just 15%. Even a 30% markup amounts to a gross profit of only a little more than 23%. At 10% net profit for the company and 10% for owner's salary, this leaves only 3% for all other costs, a painful thought.

So how can you find extra margin to make up for that lower gross profit on subs and materials? I contend that you cannot without doing much larger volumes with greatly restrained overhead dollars and owner's compensation.

Labor markup provides virtually the only way to boost margin using the T&M system. Some of our T&M brethren charge upward of $50 per hour for field staff. Many T&M firms use even lower rates for work done by apprentices, laborers and sometimes designers and other office staff. When we estimate, we use $80/hour, regardless of the staffer performing that work. This amounts to a markup on labor of more than 115%. We can do this because we do not tell clients how much we marked up their costs or estimated for labor.

Getting close to the same margin dollars on the labor side for T&M as for fixed-price would require you to charge all of your office staff's time to work related to a specific job. I don't know many clients who would fall for that one.

You also would have to use mostly in-house labor because with T&M you cannot add enough markup to the subs' labor invoices. If you have 7,000 annual field-billable hours and the work is completed at $50 an hour, you would leave $210,000 [7,000 x ($80-$50)] on the table compared with my fixed pricing. If you have no or few field staffers to let labor markup boost margin, the T&M system virtually guarantees failure by industry standards.

When to use T&M

There are times for a mix of systems. When circumstances do not allow perfect knowledge of a situation, such as pulling out a wall, you could price using square footage or lineal footage calculated from previous jobs (profitable or not), with a T&M up-charge if something outside the spec'ed scope is discovered.

If you're doing a particular installation for the first time, you might let the client share the responsibility for the learning curve. It can take an hour to read the instructions for an hour-long job, so if clients choose an unfamiliar product, they should pay for its complete and correct installation.

We often use T&M for change orders when it is not worth the time, or the field crew does not have the expertise, to get a fixed-price estimate to the client and still keep the job moving smoothly. A signature holds the ability to charge for the different work scope, but the price comes after more information is determined. It might end up a lump sum, or you can have a predetermined formula of T&M charges. This information should be in your contract or addendum so it does not surprise your clients.

How to beat T&M remodelers

We can eat T&M contractors for breakfast by telling future clients the following about T&M:

  • You give the contractor the signature stamp to your checking account.
  • You give the contractor no incentive to finish expeditiously, efficiently or error-free. You pay by the hour, not by the job.
  • You pay for all of the mistakes, trips to the store and paperwork generated by the contractor's lack of organization and planning.
  • Your contractor allows you to pay for long lunches, coffee and cigarette breaks, and probably his junior carpenters at journeyman rates. Heck, you even get to pay by the hour for the time he takes to bill you. Clients also are asked to pay for scheduling and production activities not even broken out on time sheets.
  • You pay for the contractor's on-the-job training or education.

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