The Profit Puzzle

How much markup is enough

By Steve Saucerman

The key to controlling profit will inevitably lie within a well-conceived company strategy, firm establishment of policy, and consistent monitoring and assessment of expenses.

Warning!

The following word may not be suitable for younger, impressionable magazine audiences:

PROFIT!

I'm sorry, but in order to discuss it, I had to say it. I just hope you were able to get your young ones out of the room in time ... after all, we all know (from what we hear) that profit is one of the dirtiest words around. Isn't it?

Confessing Our Sins

But perhaps we're being too judgmental. Maybe profit is just misunderstood. Let's take a look. First, as a contractor and businessperson, you need to ask yourself the following fundamental questions about profit.

First:

Isn't profit a critical (if not the most critical) element of a stable and prosperous business?

and secondly,

Doesn't any honest businessperson - who's performing a quality service at a fair price deserve to earn some profit for his toil? Of course, if you're being honest, the answer to both questions is simply and unabashedly: yes. So, having confessed our sins and openly admitted ownership of this most horrific of human avarice (which some call greed), let's take a few moments to examine the concept of profit ... and decide together how dirty of a word 'profit' really is.

Responsibility & Hierarchy

As contractors and business-owners, we have a lot of responsibilities; some large, some small, and some that we wish would just go away. But, it could certainly be argued that we hold no higher obligation to ourselves, our families, and to our employees than in that of keeping our doors open. Solvency is truly at the top of our responsibility ladder - after all, if there's no business - it's no use sweating the details over the retirement plan! So, first and foremost, the contractor/owner must insure that the revenue generated from his services is not only adequate to cover his project costs and office expenses, but in addition, generate a measured additional revenue (profit) to provide for both unforseen (cash-depleting) events and also to insure future growth for the company. Now, this isn't as easy as it sounds - and isn't as simple as arriving at the one perfect, golden profit percentage number. That number doesn't exist - at least not in and of itself. There's much more to it. Profit will only come once it has been buttressed and fortified by a carefully conceived, sustained, and consistent company action plan that encompasses accurate job costing, job efficiency, fiscal-cognizance, and (perhaps most important) willingness - yes, even enthusiasm - on the part of you and your employees in turning your profit goals into reality. Yes, of course you need to arrive at a percentage(s)[1], but these percentages aren't worth the paper their written on if they're not backed up by all of the other operations of the business.

A Different Kind of Business

So, we begin our program, but right off, we encounter a stumbling block. We're in construction contracting. We don't sell widgets. Our product is no where near as touchable and discernible as the more comprehendible manufacturer's product line. There, you can actually view and touch the product - from beginning to end and in all of it's parts, pieces, and stages - throughout the course of its creation. Most everything is definable, quantifiable, and therefore, more addressable should problems or needed adjustments arise. In contracting, we don't enjoy this level of control. As much as we'd like to think otherwise, our command over our jobs (and eventually our profit)-even in the most professional environments - can prove mercurial and slippery ... to become effected and manipulated by a myriad of unanticipated circumstances. Better put, we're not simply talking about one (profit) number being effected by one particular stimuli (problems that degrade our profit). It's more like one conceptual number being effected by stimuli that numbers somewhere around a sold-out superdome! Degrading circumstances can come out of nowhere, causing our profit line item to become a moving target. Well, perhaps "moving" is a bit placid.... let's see .... ah, yes, schizophrenic is a better choice.

If It Weren't For All These Humans...

Now, the reasons for such volatility are many and wide-ranging, but it's safe to assume that much of the turmoil springs from the fact that we are as much a social business and a technical one. The human condition (and every personality quirk that comes with it) greatly influences our success - more so than in the more finite environment of manufacturing. It isn't enough to simply hammer out the technical end of our business. If that were the case, there would be many more that would succeed. To achieve success, we also have to own the ability to intertwine and meld into the mix the personalities and problems of those people whom we've chosen to perform our work. This, of course, can be a massive, elusive, and (very often)frustrating social exercise; ranging from workers not showing up to project manager's alienating an owner by mouthing off. It can also be the difference between the workmanship and attitude of one worker over another. In the end, all of these human attributes come back to (often adversely) effect our profit. So, let's take a moment to examine the profit motive, weigh the social and technical aspects, and discuss some steps that you - the owner/contractor can take to gather back control of this slippery - yet all too critical - business element.

Profit

Let's define profit. Simply put, profit is the revenue that is left over after you pay off all expenses on a project(s), cover all office overhead costs (for the project & the office), and pay all taxes owed the government. So, knowing this, it becomes apparent that the first thing you must do is have a firm handle on your costs. Here's how I break down the costs to a typical job. The total net cost is generally arrived at by combining:

Labor costs

Material costs

Project overhead (directly related or attributable to one
particular job in progress, also referred to as general requirements or GR's)

There is another overhead known as office overhead (more related to the day-to-day cost of doing business - and less assignable to any particular job in progress). I like to set OH off to the side, and let it become a factor for later determining a profit percentage. Now, once the total actual cost (to the contractor) of the project is determined, the profit line-item is added and the final proposal cost is ready to be presented to the owner.

Directs Vs. Indirects

Each of these categories are then further broken down in direct or indirect costs. Direct costs (or directs) are those expenses that can be specifically (or physically) connected to the actual material, labor, supplies, and equipment used on a project. Other attached peripheral job costs like shipping & freight, restocking charges, cranes & hoisting, and scaffolding & staging could also be included as part of a direct line item. Indirects, then become those outlays that are more associated with the peripheral aspects of the work. For project overhead, this includes items such as insurances, bonding, administration costs, and general office duties that can be attributed to a particular job in progress. Car and truck expense (including insurances, fuel, and maintenance) can also fall into this category.Wage and benefit costs due to labor (i.e. worker's comp, benefits,health & welfare, retirement - and so on) could also be included as indirect expense ...although I've known contractors in the past to include this particular expense within their direct line items.

But that's OK. You see, like the term overhead itself, the delineation as to what is direct and indirect can often get quite cloudy. But over the years, I've found that frankly it becomes far more important for you to be consistent as to where you place a particular line-item and not so important that you get wrapped up in the definitive aspects of what constitutes direct or indirect. In short, if you feel a particular cost is a direct cost, put it there ; but then put it there every time! This organization is paramount, because only after you gain a firm grip on the costing procedure can you begin to determine and eventually assign an appropriate mark-up (profit) to your job.

Ok, So How Much Profit is Enough Profit?

So, let's assume that you get your costing under control. Well, we're not out of the woods yet! Now we have to come up with a profit percentage ... and, as we spoke earlier, it's not as easy as pulling a number out of a hat. There are many considerations - and it basically becomes a decision that is arrived at through a combination of factors that include:

Your Office Overhead cost (that we mentioned above). Ideally, this would be broken down proportionately (as close as possible) to the value of the job as it relates to the total value of all the work that was done for the year. For instance, if you have a one million dollar job to which you want to assign a markup, and your overall annual sales volume is $10 million, then you could calculate 10% of your yearly office overhead cost (using the actual previous year's record) and factor that amount into your markup.

Your local market economy and activity. Depressed market = less markup; active market = more markup will likely be allowed.

Your competition - not just how many, but also how aggressive.

The amount of revenue that you feel you need to perpetuate growth for your company. Or better put, how much you need to tuck-away for future endeavors such as that new, larger office, new computers, or other capital expenditures like new excavating equipment. This forecast is all part of the basic business plan that every owner should sit down and map out when launching and operating a business ... and re-visit periodically to assess, check progress, and adjust. This should be (as much as humanly possible) an actual dollar amount - nothing vague or obscure. The less defined and more general the target, the easier it will be for everyone to loose focus of the goal.

Your business strategy. Sometimes, it simply does make sense to "go after one" - with the hopes of winning favor (with perhaps a high-powered client) down the road. Higher-profile customers can often cause a contractor to think along these lines.

Your current work load. If you've got your people busy - and it looks like they'll stay that way for awhile - there may not be such an immediate need for quite so competitive of a profit line item.

This information will give you a basis for your profit percentage. Call it a "steering mechanism". But, just because you have a profit number doesn't mean your job is complete. Now that you've arrived at an amount on paper, you need to go out and protect it!

Negative Impact

Let's examine some of the do's & don'ts of maintaining a consistent profit line-item. Here are a few common contractor profit pitfalls ...accompanied by some suggestions to help lessen (or even eliminate) their negative effects:

Unexpected problems and miscommunication in the office or field. This is a big one and fortunately (or maybe unfortunately) the remedy to this problem is in direct relation to your ability to manage the job. Problems are going to pop up. Limiting your exposure is the key. Thorough and defined company discipline, increased communication, and careful record keeping (especially when keeping daily and weekly job logs) can greatly help reduce the negative effects that these virtually unavoidable events have on your profit line-item.

Unreasonable aggressiveness, impatience, and misguided human intuition. This is particularly prevalent at bid time - especially if you haven't hit one in a while.

Not paying attention to scale. As the dollar volume for the project goes down, the profit percentage generally goes up. This becomes especially important with very small jobs - say under $2,000. The logic is simple. It simply doesn't make much sense (unless the contractor has other motivations such as developing new or on-going relationships) to get 10 percent on $2,000 (or $200) when it costs $42 an hour just to leave the office.

Losing track of the big picture. You will have (I haven't met a contractor who hasn't) have the occasional bad jobs that "break even� (or worse). Don't panic. The overall name-of-the-game - the big picture - is profitability. If you're generating adequate profit at the end of the year to cover your business plan from above, then your probably getting reasonable profit. If the amount is too little - and all other aspects of the business are positive and in order - than an increase in your profit line item may be in order.

Your overhead growing disproportionately faster than your work volume. Become cognizant of your office overhead cost. Try expressing it as a percentage of your total volume - and work it into your normal regimen. For example, if your total work volume is $3,000,000 and office overhead $240,000, this percentage would be 8%. As your company grows, periodically (at least once a year - after the books are done) monitor and compare this percentage to your current situation to make sure you're in line. Violent spikes or abnormalities in the overhead percentage should throw up a red flag. Now, this percentage will likely shrink in proportion to gross volume as the business expands. There will also be intermittent fluctuations (such as large capital outlays for equipment), but overall, it should be a relatively even, straight-line movement. Adjust as you deem necessary, and don't forget to factor in inflation, anticipated salary hikes, and upcoming benefit increases. �Not understanding the basic concepts associated with construction costing and pricing. Two words: educate yourself. Know how to put an estimate together. There is no such thing as a "guestimate".

Not obtaining the best possible prices for your materials and sub-contractor pricing. Every dime that you spend that's too much (whether through lack of or laziness in negotiation) is exactly the same as taking money out of your profit till.

Not controlling overhead costs. Knowing your overhead costs isn't enough. Is your office located in a location that's too expensive? Are your salaries in line with the market? Are your vehicles maintenance hogs? What about the location itself? Are you near potential activity, subs and suppliers, plan rooms, architects, etc? If not, you may be spending disproportionately high dollars on simple everyday transportation and mobilization; dollars that may outweigh that "great deal" you've got going out in the country.

Basing your pricing on competitors. Of course, every smart business man needs to know where his competition is. But it's poor business to let that consideration solely determine your profit line item. Arrive at your own numbers - and they will eventually work out just fine. You're smarter than you think, and I've seen far too many contractors go belly-up to give much credence to every low-ball price that's scattered around out there. The only important profit line is your profit line.

Of course, this luxury normally only comes attached to a contractor who is established, venerable, and can back up his claims. Over the years, they've proven they can provide quality service, deliver a professional product, perform punctually, handle customer complaints and warranties, and overall, are generally knowledgeable, friendly, and helpful. There really are customers who don't mind paying for these qualities - and are probably getting a better "deal".

Conclusion

And there are likely even more considerations and more ways to boost your profit. For instance, have you thought about focusing on a niche, specialty market - such as school or medical work? Developing a reputation as a specialist can get you into more negotiated deals (generally good for profit) and focus that comes with specializing tends to inevitably increase the efficiency of the work itself - another solid profit builder. By eliminating variables - variables that often cause problems that deplete profit - the contractor can better define - and hone in on - those items that produce positive cash flow and perpetuate higher profits.

But in the end, the key to controlling profit will inevitably lie within a well-conceived company strategy, firm establishment of policy, and consistent monitoring and assessment of expenses. Then, it becomes equally paramount to establish a true sense of purpose - call it enthusiasm - among your employees in controlling the profit line item. This can be in the form of incentives or bonuses to your staff ... or some other positive reinforcement. Threats don't work. The trick is to educate and motivate. If you're on the right track, the people around you will pick up on it. The important thing is to do something. You know your people best, and you'll soon come across a method that works best for your situation.

[1] You could very well forego the percentage in lieu of a lump-sum amount (above and beyond costs), but for the purposes of this piece, we'll focus on the percentage method - simply because I've found it to be more common.

About the Author

With over 25 years in construction, primarily as an estimator and project manager, Steve Saucerman now writes, speaks and consults for the construction industry. He also teaches part-time in the Building Construction Technology division for Rock Valley College in Rockford, Ill. He has published two books and over 350 articles to date and his writing is featured in construction periodicals all over the world.

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