Business coaching: Markup, Margin and all that stuff
By Mike Draper
As a business coach, I ask a lot of business owners if they know the difference between Markup and Margin. Invariably, most say yes. What I later find out is that they know they are different, but aren’t really sure how and why. Let’s do a deep dive into Markup and Margin and show you how to calculate how much Markup/Margin you need to be applying to your quotes.
First, let’s provide a definition in the context of construction:
Markup: It is an amount added to the cost of doing a renovation in order to calculate the final selling price to the homeowner. The markup must take into account overhead and profit.
Margin: can be broken into 2 different definitions:
1. Gross Margin: It is the difference in the selling price to the homeowner and the job costs of doing the renovation, excluding overhead and profit.
2. Net Margin: It is the difference in the selling price to the homeowner and the cost of doing the renovation, including overhead and profit.
For the purposes of this article we will focus on Gross Margin when margin is referred to.
The common way of pricing out a job is to scope out the work the client needs, ask them what their budget is, calculate all the costs of doing the work on the job and then try to calculate a price that is within the homeowner’s budget. There are some variations to this process as sometimes a contractor can’t get a budget figure from the homeowner. In this case the contractor typically figures out how much they think the job is worth and the homeowner’s ability to pay for the renovation. It’s not very scientific.
A better approach is to know how much you have to markup the cost of doing the renovation so that your company can make a profit after all the expenses of the job and the company are paid for. Understanding the previous sentence, and its significance, is the basis of this entire article. So let’s say it again: Your Markup has to be high enough that the selling price the homeowner pays for the work will cover all the costs of doing the project plus the overhead and profit associated with that job.
Breaking that statement out into smaller pieces would look like this:
When a project is priced out, there are two different types of costs that need to be covered by the price the homeowner pays. There is the cost of the job (also known as Cost of Goods Sold (COGS) and the overhead costs the company incurs by being in operation (also known as Operating Expenses or OP).
Examples of Cost of Goods Sold:
- Materials for a job
- Sub-trade costs
- Machinery rental costs
- Job site permit costs
- Site demolition removal
- Porta potties
- Delivery expenses
- Labour on the job
Examples of Overhead Operating Expenses:
- Insurance of all types
- Office expenses
- Marketing expenses such as website, trade shows etc
- Office administration expenses such as bookkeeper, accountant, lawyer etc.
- Vehicle expenses
- Cell phone
- Education and training
Some of this information may seem a little daunting at first. However, it is critical for determining your Markup. Without knowing your true costs, you will never be able to calculate the Markup you need to be charging to make your target profit. This, in itself, is one of the biggest reasons contractors don’t feel they make enough money at the end of the year. They know that throughout the year they charged more than their Cost of Goods Sold, but wonder why there is not enough money left in the bank. The main reason is they didn’t markup the job enough to cover the overhead operating expenses and make a profit as well as the cost of doing the project.
Let’s take a look at how you need to calculate your Markup – and it is not based on what your customer is willing to pay! Let’s use this example and assume that you know what your overhead expenses are based on the financial statements from last year’s books.
Basic Markup Formula
10% net profit $ 50,000
Total overhead & profit $150,000
Total Revenue $500,000
Less O/H and profit $150,000
Total Direct/job costs $350,000
Divided by dir/job costs $350,000
Markup Factor 1.43
Markup % 43%
In this example you will notice that we talk about 10% profit. Profit and owner’s salary are not the same thing. The business owner should be paid a salary to run the company effectively, whereas profit belongs to the company. The company needs to make a profit so that it can reinvest for growth, pursue new opportunities and provide a return on any shareholders’ investment in the company.
Typically, a minimum profit objective is 8%, an average company is 10%, but we believe a well-run, efficient construction company should make 15%.
Gross Margin = Total Revenue – Direct/Job Costs
Gross Margin % = Gross Margin Divided By Total Revenue
So in the example before, Margin would be calculated like this:
Gross Margin = $500,000 – $350,000
Gross Margin % = $150,000/$500,000
Therefore, the Gross Margin would be 30%
You can now see how a 30% Gross Margin is a 43% Markup!
So what does all this mean to you? Well, if you run your own numbers and they look anything like the numbers in this example then you need to be adding 43% Markup to every project you do. Are you thinking “There is no way that I can charge that much for my projects”? It’s understandable if you are. It goes without saying that you can only charge what the market will bear. Hence, the dilemma faced by many contractors. How can you make enough money on every job and yet not price yourself out of the market?
Remember, lowering your price without changing the scope of work or your cost base is a guaranteed recipe for not making enough money. If you don’t believe it, go back and re-read the formulas. Since they are math, they tell the true story.
There are two ways to look at this. First, you have to reduce your cost of delivering your projects. Since you have to apply the margin that will provide your company with enough profit, one way to remain competitive is to lower your costs. You have to find a better way to deliver the service you provide and you have to lower the price you pay for your materials and finishes. This is one reason that we created the Group Buying Program for our Renovantage members who typically enjoy 40-50% savings.
Second, you have to match the type of customer to whom you are providing services to a level of workmanship that they are willing to pay for. If they are not in sync, you need to either find a new level of customer or you have to change your level of workmanship. A lot of contractors are not willing to adjust their workmanship, which is fine, but then they have to be willing to change their client base.
Let’s take a look at what happens if you don’t make the adjustment and add enough Markup or you let a client force your price down.
Here are some very common Markup formulas used by contractors that actually don’t work!! Based on the traditional model of calculating price by calculating your costs, then adding a percentage for Overhead and another percentage for profit, the formula looks like this:
Price=direct/job costs + overhead + profit
Now if we take the original example again with a cost of $350,000 and Overhead of $100,000 (20% of $500,000) and add 10% profit, look at what happens to the numbers:
$350,000 + 20% + 10%
$350,000 + $70,000 + $35,000
Sales price = $455,000
You would be leaving your company short by $45,000 of pure profit. That is a huge difference! Imagine leaving $45,000 in pure profit on the table. How did that happen? It’s simple. This is the wrong Markup formula and yet it is used by so many contractors.
Another killer formula is the Cost-plus method. The problem with it is that nobody knows your overhead and profit percentages and they really don’t care!
They expect 10% overhead and 10% profit and it’s not enough. We don’t know of a single renovation contractor that has 10% overhead. The average is more like 25%. Also, if you have invested in systematizing your business so that it can operate more effectively than your competitors, why shouldn’t you be able to make more money than your competitors for doing the same work? If you have better buying power than your competitors, why should you have to pass all the savings along to the homeowner?
Time and materials is also very common and again it is a bad formula. Clients will nickel and dime you to death and when there are leftover materials it can lead to disagreement.
How about the “adjusting to suit other competitor’s price” strategy? This price dropping is all too common and the pressure to do so is enormous. The big problem with this pricing strategy is the competitors may not know what they’re doing, or maybe they may have made a mistake. Their numbers may be wrong, or even worse, they may be working only for wages, and not want a profit.
Closely related to the last one is adjusting Markup to suit a client. Some clients may even tell you what it should cost. Ask them how they arrived at that price as they may have wrong information, and you can educate them on the true cost.
The bottom line is that you need to get control of your business, your costs, your Markups and your profits. Make this your practice:
– Negotiate what you’re going to do
– Negotiate how you are going to do it.
– Negotiate where and wehn you are going to do it.
– Never negotiate how much you are going to charge!
If your current customers won’t pay you a fair price for the work you do so that you can make a profit, then you have to either get new customers or change your business model. If you keep doing what you are already doing, you will continue to get the results that you already have. So spend the time to really understand the formulas that we have shared in this article and apply them to your business. It is possible to make the money of your dreams!