The Profit Puzzle
How much markup is enough
The following word may not be suitable for younger, impressionable magazine audiences:
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?
Isn't profit a critical (if not the most critical) element of a stable and prosperous business?
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.
- 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)
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.
- 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.
- 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 evenÓ (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. There is a curious variation on that above, and that's when a company adopts the stance of pricing above (yes, higher!) than the competition ... on purpose.Of course this strategy is possible only when price is not the primary issue with the customer (which is rare) and there are normally other associated factors, all of which have to do with that contractor convincing the owner that it's indeed justifiable, based on the contractor's credentials, to pay the higher price. I call it the "Curtis-Mathis" approach to contracting (remember, "the most expensive television in America ... and worth it!").
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.
 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.