The Profit Series Part 1: Why Profit?
Profit is not a dirty word. You need to understand what it is, what it means and why you need to make lots of it.
By Mike Draper
Today we had a request for the online version of this article from a contractor who recalled it, but could not locate it. It’s an “Oldie but Goodie” from contractor coach Mike Draper, first published March 8, 2012.
What profit is not
Profit is not “How much can you squeeze out of this homeowner?” It is, however, about how to squeeze more out of your business by making it better. How can you make your business more systemized so that it runs more efficiently? How can you reduce your costs, yet still deliver on your commitments and standards? How can you sell projects with higher value? These are some of the questions to ask yourself when you look at making more profit.
There are three key numbers that every business owner must look at when assessing if their business is making enough profit. Only when you understand these three numbers can you evaluate your profit. You deserve to make a fair profit and must structure your business to do so. The first number is how much you need to pay yourself for the work you do for the company. Second, how much profit the business makes in relation to the company’s sales and finally, what return on investment (ROI) you receive for the money that you have invested in the company.
Gross and net profit
This is the perfect time to talk about gross profit versus net profit. They are not the same thing. Gross profit is the difference between revenue and job costs before deducting overhead expenses such as office rent, phones, vehicles, insurance, office expenses and supplies, computers, accounting and bookkeeping, interest payments and the like. Net profit is what is left after subtracting all job costs and overhead expenses.
Wages are wages, not profit
You should pay yourself a competitive wage or salary for all of the jobs that you and your family members perform. These wages are not profit! You are performing duties that are necessary for your company to sell and deliver services to your customers. Somebody has to do the work. Profit is what is left after all expenses have been paid, including the owners salary and those of family members who work for the company.
Here are a few guidelines as to how much you should pay to have various tasks performed in your company. The amounts suggested are what a typical Canadian renovation company pays as a percent of revenue:
Job supervision or project management 4%
Owner’s salary 6-8%
Let’s go back to our example where the business generated $800,000 in sales. If you are the owner and you are performing all of these functions yourself, I guarantee that you are not working 40 hours a week. Most likely you are working 60 hours per week or more. If you are doing the equivalent of two full-time jobs, you need to pay yourself accordingly. In our example of an $800,000 business where the owner performs project management, sales, bookkeeping and the entire normal business owner tasks, the owner should be paid a salary between $128,000 and $168,000. Think about it. Could you hire two people to do all of that work for $128,000 per year? I doubt it.
The break even point
The break-even point is when your total sales match your total expenses. The cost of the work that you do must be included when looking at your break-even point. To calculate break even, use this simple formula:
Overhead costs/percent of gross profit = Break even point.
The break-even point in our example is: $160,000/.30 = $533,333
Return on sales
The second area to review is how much profit does the business make in terms of return on sales (ROS)? Comparing profit to sales volume is not a calculation many contractors make. I am surprised, since this number is what enables you to make investments into your future growth. Without a ROS, the business can’t invest in its own future. And a business that is not growing will eventually die.
So what is the ROS number anyway? It is a simple calculation done by taking your net profit and dividing it by your sales. Show the result as a percentage and that is your ROS number.
In the example above, after the owner paid himself for the work he had done and covered all overhead expenses, his business made a return of 10 per cent. You should target eight per cent as the lowest percentage that your company should make, while 10 per cent is okay and 15 per cent is considered healthy. At 10 per cent, your company has money to invest in its future and can give shareholders a return on their investment. You might need to redo your website, buy a new truck, and invest in marketing to fuel your growth or hire a project manager so you can reduce your hours to a more manageable level. Whatever the reason, you need to be making a respectable ROS.
Return on investment
The third number represents the return on any money that has been invested in your company. There might be a lot of reasons why you have money in your business. You might have bought the company tools with your personal credit cards and not paid yourself back. You probably needed start-up capital money when you first started. You might have put in personal money to help with cash flow. If you have any of your money invested in the business, then the business needs to be able to generate enough profit to pay you a competitive ROI. After all, if the company had to borrow the money from the bank instead of you, the company would have to pay interest on the money. Now you might be thinking “I had to make the investment because the bank wouldn’t lend my business the money.” Regardless of the reason, if you hadn’t lent the business the money it would be earning you a return somewhere else.
Here is an example of a typical investment to set up a (very) small reno firm
Business startup costs $15,000
Owner purchased some materials on a personal credit card $20,000
Costs to set up a home office $5,000
Owner’s capital injection $25,000
Owner “sweat equity” $50,000
Owner’s total investment is $115,000
Typically you would expect a three to four per cent Return on Investment if you put your money in GIC’s or Blue Chip Corporate Bonds. You would probably want to earn seven per cent or more if you invested your money with a stock broker. Money invested in a small contracting business is significantly more risky than putting your money in the bank, so you need to earn a far greater return.
A well run business with consistent cash flows and profits could expect to sell their business for 2.5 to 3.5 times earnings. Most renovation companies are worth nothing because without the owner being there, there isn’t a business. As such, you could only attract outside investment in your business if you were to offer at least a 20 per cent ROI. Typically, you would need to offer 30 to 40 per cent ROI to attract an outside investor. If that’s what you would need to pay for outside funds, that’s what you should make on your investment. In our example, you should earn between $34,500 and $46,000 on your $115,000 investment.
What profits are for
Profits belong to the company and are typically used for the following:
1. Pay dividends to shareholders.
2. Retained in the company to pay for future investments in order to grow the company, such as hiring new employees, buying new technology or increased marketing expenditures.
3. Create a Capital Reserve Fund so that the business has enough cash to weather a downturn or a cash flow crunch (we recommend a Capital Reserve Fund).
This means you need to earn a sufficient gross profit to cover all of your overheads and still have an adequate net profit. If your salary is 16 to 21 per cent of revenue, add in all of your other overhead expenses and then you add 10 per cent for profit, you will typically need a 30 to 35 per cent gross profit.
Mike Draper is a business coach for Renovantage and a frequent contributor to Canadian Contractor. www.renovantage.ca