The Profit Series Part 2: Markup and MarginCanadian Contractor Adjust Business Financial Insurance Market Service Vehicle
Knowing the difference between Markup and Margin can make or break your profit strategy
By Mike Draper, Business Coach, Renovantage.ca
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. In this issue of Contractor U we are going to do a very deep dive into Markup and Margin and will 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 for both:
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:
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.
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.
On December 11, 2011, Robert Koci created a video which talks about why you need to make a profit and what that means. Profit is the basis for the need to understand the importance of markup vs. margin.
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 2 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) and the overhead costs the company incurs by being in operation (also known as Operating Expenses).
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?
nderstandable if you are.
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 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.
Second, you have the type of customer to whomyou are providing services to
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 systemizing 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’re going to do it
– Negotiate where and when you’re going to do it
– Never negotiate how much you’re 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!
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great article. Thanks for explaining the business side. A few questions:
1. Are taxes taken into account in the above?
2. If as a GC I am charging my carpenters at $45/hr and paying them $30, do I chalk the spread up to gross margin or profit? Or should I treat the $15 as the basis for covering my overhead.
newbie to the paper side.
Appreciate the feedback.
1) In all of the calculations in the article, tax, of any kind was not included in the calculations.
2)The $15 delta from what you charge for a carpenter and what you pay them is Gross Profit. Margin is usually expressed as a percentage so your gross margin is 33%.
The Gross Profit has to be enough to cover overhead and profit. You will have billing time, payment time and booking costs associated with the carpenter. You might even have other costs that are a direct result of hiring that carpenter. So all of those costs and profit on the carpenter have to be covered by that $15. Hence why your markup needs to be so high.
I think I have wrapped my head around the above and boy am I missing out :)!
Another Q: The Net Mergin is a calculation that I would calculate after the job is done? Because according to this statement,:
“Net margin: It is the difference in the selling price to the homeowner and the cost of doing the renovation, including overhead and profit.”
I get a zero?
I was very interested in your article, succinct and to the point – albeit way over my head in financial terminology. BUT, did glean a lot of good information. My question is: We live on Vancouver Island in a very competitive market, where there are tradespeople working just to get enough money until they can go back out fishing or back to the oil patch. So we are constantly up against quotes coming in 1/3 lower than us and I only markup materials 15% …. and our hourly is very reasonable. We have amazing clients who do value our work but that pool of influence is limited in such a small community environment. We run a fully insured, accountable business and have never had to advertise as our business comes in through word of mouth and chance meetings. May I ask a very naïve question? If we are doing a job and subcontract out for an item what is the formula for markup ? Say the item we have ordered for the client is $2010 plus gst – do I do a straight 15% on the 2010? thanks for any input.
Sasha, if you mark up your subtrade’s bill to you of $2,010 for that item by 15%, or multiply by 1.15 obviously, you will be charging your client $2,311.50. So what is your gross margin profit on that item? Your profit is $2,311.50 less $2,010.00 = $301.50.
Your profit percentage, or margin percentage, will be $301.50 divided by $2,311.50 = THIRTEEN PERCENT. So your final gross margin profit is always less than your mark UP percentage. You can do your own math on whether 13 per cent profit on that item is enough. On the job itself, I hope you aren’t just making 13 per cent, because after you pay your non-job-specific overheads: WSIB/private insurance, vehicles, tools, office costs, shop costs, depreciation, accounting fees, permits, blah blah blah blah blah, then that 13 per cent gross profit will look like a LOSS on the year. So that is why you need to be making way more than 13 per cent generally. On this job, for that item, maybe it’s OK. Only you know. Keep in touch.
I was paid commission based on the gross profit on restoration projects. Over the course of some projects, collateral damage unrelated to the project scope (damaged appliances, unplugged refrigerators for example) would occur as a result of carelessness by employees. Other times warranty work would be done a year or more later.
In your opinion would these uncontrollable unforseen costs be costs of the project or overhead costs, the cost of doing business? These type of events can not be accounted for in the estimating process. My income however was directly affected by the negligence of others….
Thankyou for the article. After giving a very clear price to a client, they want a inch by inch, dollar by dollar break down. I have been used many times to get numbers and then I get dropped. Should I put my foot down or just do the break down. I have spent already a week on this large estimation with no deposit yet.