Business Articles - Money Management
Articles & Tips
Many magazine articles advise contractors to apply a "professional markup" to their bids. But what, exactly, is a professional markup? Does a 50% markup make you a professional, or should you apply 67% to qualify? The simple answer is, if you don't know what markup your company needs to use, you're not a professional, and therefore you're not using a professional markup. But if you know the formulas for determining margin and markup, you have a working financial tool, rather than a magic number suggested by some remodeling guru.
Different Markups, Same Price
To determine your company's markup, divide your anticipated annual indirect costs (costs of overhead and profit) by your anticipated annual direct costs (costs to produce projects):
|
Company A |
|
Company B |
Thus, if one company considered its field employees' health insurance a direct
cost, and another company defined it as an indirect cost, those companies would
apply different markups. In theory, if both companies had all of their other
costs covered somewhere within their annual budget or estimate, they'd sell
their projects at the same price, even though their markups differed. Remember
this the next time you're impressed or puzzled by what your fellow contractors
claim to be using as a markup.
Targeting Your Margin
To determine the margin your company needs to maintain while completing projects,
divide your budgeted annual gross profit amount by your total anticipated sales:
|
Company A |
|
Company B |
To see if a single project met your goals, apply the same analysis. Divide
the gross profit by the amount of money you collected at the end of the project.
The result will be an expression, as a percentage, of your gross profit margin
for that job. Here are the numbers for Company A:
|
Estimate: |
|
|
Job cost: |
|
|
Margin: |
|
Create a Budget
If another contractor tells you that he or she expects to do "somewhere between
$1 and $2 million" in volume for the current year, don't be impressed. The ambivalence
is a potential disaster sign, and certainly an indication that that contractor
doesn't have a budget.
Working successfully with markup and margin percentages requires that you maintain
accurate estimates of your direct costs, indirect costs, and a targeted net
profit amount -- in essence, a budget. By adding those three components together,
you determine your anticipated sales volume. But say you have a slow year and
don't actually spend as much on direct costs as you estimated. (Keep in mind
that your indirect costs will probably remain the same.) If you don't increase
your markup as you see this happening, you won't collect enough money to fully
cover your gross profit requirements. That in turn reduces your net profit and
may mean that you won't cover your indirect costs, either.
Volume vs. Profit
I consider profit to be my reward for the risk I take by using other people's
money to produce projects. After all, if my estimate falls short, I'm still
responsible for completing the project, and may even have to contribute some
of my own money to cover costs. I once had a conversation with another well-respected
remodeling contractor in my hometown who bragged that his volume was twice that
of my company. Then I asked him about his net profit percentage, and I wish
I had a picture of his face when he discovered that his percentage was half
of mine. Although we made about the same net profit in actual dollars, I had
half the risk.
If you want to make a bigger profit, first consider raising your prices on your
current volume. Only after you reach your profit goals on your current volume
of work should you consider producing more work.
If this year's budget includes the same dollar amounts for your direct and indirect
costs as the previous year's budget, but you want to add profit to the budget,
then your sales volume will have to increase. You won't need to produce any
more work, but you will need to sell it at an increased markup and a higher
price than last year.
Trade-offs
Keep in mind that the total annual dollar amount of the direct costs in your
budget must remain the same if your markup doesn't change. But the actual breakdown
of expense accounts that make up the total can change: If your burdened labor
costs go down by $56,000, but your subcontractor costs go up by the same amount,
you'll still be on budget.
Knowing this, you can explore options: If you increased your material costs
by specifying and using higher-priced products, you could possibly reduce your
burdened labor costs proportionally without compromising gross profits. For
example, if you switched from being a vinyl siding contractor to being a kitchen
and bath contractor, you might boost your volume without needing to hire additional
employees. After all, the typical cost of materials for a $20,000 vinyl siding
project is much lower than the cost of materials for a $20,000 kitchen remodel.
This scenario assumes, of course, that your employees have the required skills
to make the switch, or that you replace them at a similar burdened labor cost.
Tracking Gross Margin
Be careful when determining your company's overall gross profit margin for completed
projects. I once made the mistake of adding up all the margins for each project,
then dividing that total by the number of projects. Trust me, it doesn't work
that way. That method could indicate a healthy margin when, in reality, you're
in big trouble. Let's say you do five projects and want to determine your true
overall gross margin. The correct method is to add up all of the money you paid
out to complete the five projects and then divide that sum by the total of all
the money collected for those same five projects.
|
Incorrect Method for Calculating GPM |
|
Correct GPM Method |
The two examples show a difference of 9 percentage points. For a company doing
$1 million in annual sales, that difference amounts to $90,000 in gross profit.
If you used the first example to determine gross profit, you'd assume you'd
earned way more than you actually did -- at least until you thought about paying
for your true overhead and profit. I guarantee you would make this mistake only
once!
by Shawn McCadden
Shawn McCadden is president of Custom Contracting in Arlington, Mass., and cofounder of the Residential Design-Build Institute, LLP.
This article has been provided by www.jlconline.com. JLC-Online is produced by the editors and publishers of The Journal of Light Construction, a monthly magazine serving residential and light-commercial builders, remodelers, designers, and other trade professionals.
Join our Network
Connect with customers looking to do your most profitable projects in the areas you like to work.
