Having been in the residential building and remodeling business for many years, this is one of my favorite questions. I think many highly skilled craftsmen fail in business because they don't understand (and haven't had the opportunity to learn) basic business mathematics. Unless a person just starting out in the contracting business has deep pockets, they are almost certainly doomed unless they have an understanding of the business basics.
The hardest problem to overcome initially is the psycological problem of learning to charge enough to pay the bills and retain enough profit to grow the business. Knowing that the hard costs of material and labor will be $1,000.00 and asking the potential customer to pay $1,670.00 is foreign to most tradesmen. The ingrained philosophy is to "be the cheapest" in a competative world. There is also the guilt associated with the thought that you might be ripping off the customer by charging too much.
You need to sell value and quality for a fair return. The fair market value of any item is that upon which the buyer and seller agree. Trying to satisfy a customer who wants to buy the cheapest will doom you to failure. You can't run away from them fast enough. Learn to say no.
On the subject of profit, you are looking for "markup" which will generate "gross profit". Let's look at costs first. There are two types of costs to consider.
The first costs associated with the project are "Direct Costs". They include both material and labor (be sure and include your own labor if you will work on the job) directly attributed to the cost of constructing the project.
The second costs associated with the project are "Indirect Costs", otherwise known as the "cost of doing business". They include the costs of being in business that are not directly attributed to the cost of constructing the project. They include, but are not limited to, vehicle costs, business insurance, advertising, phones, tools & equipment, office supplies, etc.. All are must haves to be in business and all will be paid for out of your gross profit ("margin").
Make a list and add up of all of the indirect expenses you expect to incur over a years time. You commit to spending for these expenses. You will have to recoup these expenses out of the gross profit ("margin") you generate just to keep your financial head above water.
Remember, if you own your own business, you are entitled to two streams of income. The first is as an hourly worker pounding nails on the job. The second is as a business owner with a capital investment and the right to not only recoup the costs associated with that investment, but to realize a profit at the end of the day. Otherwise what is the point of being in business for ones' self? It is far easier to work 8 to 5 for somebody else and let them spend their evenings and weekends selling, pricing, planning, etc., and have all the headaches of owning a business. Now lets talk about markup, margin, and profit.
Let us make some assumptions:
- You intend to work on the job pounding nails and will make an hourly wage for your efforts. You will attribute these wages to the "Direct Cost" of each individual job.
- You have carefully calculated that your annual "Indirect Expenses", or "Cost of Doing Business" will be $25,000 and have budgeted accordingly. You commit to spending this money in running your business. You have not included a salary, draw, or other monetary compensation to yourself in this calculation since you are going to be pounding nails for the time being.
- You think a 25?markup" is fair (I think it is low, but more on that later) and that that is the number you will use to "markup" the jobs you sell.
So far, you have done everything right, but there is danger just around the corner. The most common error is the confusion between "markup" and "margin". "Margin" is your monetary gross profit expressed as a percentage, in this case 25? "Markup" is is the mathematical tool used to get you the 25?ross profit or "margin". There is an easy way to do this.
To realize a gross profit "margin" of 25?multiply the total direct cost of your job by 1.33 (this is your "markup"). A job whose direct costs total $1,000.00 must sell for $1,333.00 for that 25?ross profit "margin" to be realized. Your monetary gross profit will be $333.00. Remember that your "indirect expenses" will be paid out of your gross profit (also known as your "margin". Mathematical proof: gross profit divided by selling price equals margin or in this case 333/1333=24.9?
The biggest mistake most new Contractors make is to multiply their "direct costs" by their intended "margin" and add it back to their "direct costs" to arrive at a selling price. In the above example that would be $1.000.00 times .25 (or 25?equals $250.00 added back to $1,000.00 equals a selling price of $1,250.00. Now let's go back to the mathematical proof: gross profit divided by selling price equals margin or in this case 250/1250=20.0?But wait, you budgeted and committed to spending $25,000.00 over a years time and decided to operate at a 25?argin! If you calculate your selling price in this manner we have just proven that you are quickly going in the hole.
Most new Contractors do not realize until it is too late that they have spent more than they have earned. Unless they have deep enough pockets to afford them the time to learn from their mistakes, we have proven they are doomed to failure. You can't plan for a 25?ross margin and mistakenly earn a 20?ross margin for long. Too many Contractors sit and wonder "where did the money go?" at the end of the year. Many never figure out the math, they just vow to sell more and work harder which just hastens the inevitable.
Now lets go back to our assumptions. You understand the math. You have budgeted and committed to spending $25,000.00 on indirect expenses in the next year. You have decided to work on a 25?argin using a 1.33 markup. You are a great estimator and never make mistakes or encounter unforseen circumstances. You will pay yourself an hourly wage (direct expense) for pounding nails and will not "take anything out of the business" other than the money you earn hourly. How much do you have to sell to "break even" and pay the bills?
To calculate your "break even point", use the following formula: total indirect costs divided by gross margin equals sales volume needed to break even. In our example, $25,000/.25(25?$100,000.00. In other words, you will have to sell $100,000.00 worth of business at a 25?ross margin just to pay the bills to which you have committed. You will have earned a living pounding nails (remember you are paying yourself by the hour ... a direct expense) but at the end of the year, your business will have earned nothing. But neither will you be in the hole. The good news is, for every dollar you sell over $100,000.00, the business earns $.25 in net profit before taxes!
Now that you know your "break even point", you can plan to make a profit. If you sell $150,000.00 in volume at a 25?ross margin and stay within your $25,000.00 "indirect expense" budget, your business will earn a $12,500.00 net profit before taxes. This is the cash you need to grow your business. It provides additional "working capital", perhaps cash for a small salary for all the long evening and weekend hours out selling, the realization of a return on investment, etc. Over many years, positive cash flow gives a business value. When you decide to retire some day, someone will be willing to buy your profitable business.
Back to the margin percentage. You specify a 25?arkup. By any industry standards today, the residential remodeling business requires at the very least a 40?ross margin (1.67 markup) with many believing that 50?2.0 markup) is necessary. Some specialty Contractors use substantially higher markups.
Once you wrap your mind around the need for higher markups, youo need to learn how to sell your jobs at those kinds of prices. Believe me, it can, and is being done. You must seperate yourself from the competition in your presentations to customers and you must sell value and benefits. Selling is an art in and of itself and deserves to be addressed separately.
I always told my customers "The bitterness of poor quality lingers long after the sweetness of a cheap price is forgotten". There are quality buyers out there and you need to go out and find them.
Many years ago I learned a lot from Walter Stoeppelwerth at HomeTech located in Bethesda, MD. His Company publishes outstanding industry related books. In addition, he travels the country putting on seminars on the building and remodeling business. If you have the chance to attend one of his seminars, don't miss it. You can view the website at www.hometechonline.com.
I enjoy imparting this information and used to teach classes on cost accounting, business management, and selling to my peers in my local HomeBuilders Association.
Good luck with your business.
Answered By: exbuilder - 2/11/2006 |