3 Numbers to Know: Costs, Markup and Profit
Running a successful construction company calls for more than just winning bids and doing great work. To get ahead and make money, you need to carefully track your costs and accurately calculate how much to charge to turn a profit. To this end, there are three numbers that every construction business owner should know, review and update.
1. Total costs
To bid competitively and for the right projects, construction business owners must fully understand what it will cost to do the work. Project estimates should be as close as possible to final, actual job costs.
One way to ensure accuracy is to use thorough job costing. This approach addresses your direct costs for a project by placing a price tag on each task or activity based on resources consumed, such as materials, equipment usage and labor hours.
With job costing, three expense categories are used to calculate what it takes to complete each task: labor, materials and overhead. Add those costs together and you’ll get the true cost. Job costing requires you to start at the task level to estimate projects from the bottom up. Essentially, you’re using tasks or activities as line items, which you can easily add or delete as a project’s scope changes.
In addition, you need to be aware of indirect costs. These are typically costs associated with more than one job, such as construction equipment and workers’ compensation insurance, or costs that are indirectly related to the on-site construction, such as payroll service fees.
Finally, there’s your overhead. This generally includes rent/mortgage, office equipment and supplies, licenses and fees, taxes, utilities, general insurance, and salaries. Most businesses incur these costs to some extent.
Track all your costs regularly — don’t wait until a project is complete! Change orders or unexpected costs can occur over the course of any job. Ensure your project managers are collaborating with your accounting staff to compare estimated costs against actual costs so they can swiftly course-correct when costs start to creep up.
2. Markup percentage
Once you know the true cost of a project, you can apply a markup percentage to generate additional revenue beyond that to cover costs — rather than just breaking even. Markup is the difference between job costs and the sales price you charge clients. Subtract job costs from the sales price to get your revenue dollars.
So, a 20% markup means you’re charging 20% of the project’s job cost price. If job costs are $10,000, the 20% markup equals $2,000. Therefore, you’ll charge the customer $12,000 and receive as profit the markup amount of $2,000.
Important note: If direct costs, indirect costs and overhead aren’t all baked into the markup percentage, your company probably won’t earn the $2,000 in profit. A portion of that revenue will go toward those other costs.
Beware of contracts that limit markups on change orders. Project owners often include such language to discourage contractors from submitting lowball bids and overcharging on change orders later. However, contracts that limit markup percentages can prevent you from charging enough to cover your costs, much less retain revenue.
Although it may be impossible to avoid agreements restricting you from charging your full markup on additional work, try to at least avoid contracts that limit you to cost or cost plus 10%.
3. Sales/profit margin
Your construction company’s net profit is the amount of sales revenue left over after you’ve paid all applicable costs. For example, a 40% profit margin means you get to keep 40 cents from each dollar of sales generated.
The simple formula to determine profit is: (Net Income / Revenue) × 100. Although there’s no industry standard, one rule of thumb says your net profit objective should be no less than 8% — but more is better.
Regularly reviewing your profit margin enables you to measure your ability to maintain and build a strong bottom line. With this knowledge, you can establish a desired and realistic profit margin goal, and then set a markup percentage to achieve that goal.
Essential but tricky
Calculating the “Big 3” numbers — total costs, markup percentage and sales/profit margin — is essential but tricky. First and foremost, you need good data that’s regularly gathered, clearly displayed and accurately analyzed. We can help you establish strong financial processes, double-check your assumptions and ensure you have the right technology in place.