For any company, profit is based on the risk reward concept. So in construction, what should be the profit (reward) given the risk? What is a reasonable expectation given the industry and the particular business?
There is no single correct answer. The construction industry is divided into several significant branches. This article is focused on the residential contractor. From the new home builder to the re-modeler, a reasonable profit given the risk should be no less than 9% AND this does not include a reasonable salary to the owner for his management role. This is the take home or actual bottom line profit; the amount after taxes. How do you derive such a figure? How do you determine the markup on the construction project to end up with this profit?
I have written several articles related to this exact issue:
- Contractor’s Profitability – a very simple job as an illustration in the mindsets of both the homeowner and the contractor in determining a reasonable profit for the work done.
- Mark-Up Percentage for Re-modelers – this article restricts the formula to re-modelers and additions. The formula works exactly like the formula in this article but adjusts for the issues related to this segment of the residential construction industry.
- Margins in Construction – this particular article goes beyond the scope of just residential construction and includes those contractors in the multi million dollar range. In general the margins decrease with volume related to several factors. The formula is modified and explained in this article.
Before we answer these two questions, let’s first define several layers of profits. Once we agree to the terminology, then we can analyze the question at hand: What is a reasonable profit in construction?
Terms of Profit:
- Adjusted Contracted Revenues – Very few industries have costs in the revenue section, but contractors incur these costs. Typically a contract has a set dollar value, but when the buyer and the contractor go to the closing table, the contracted price is reduced for selling costs: broker commissions, tax fees, buyer incentives, professional fees etc. In new home construction, this runs around 9 to 11% of the contracted price. For remodelers, restoration contractors, and those contractors doing additions, this runs less than 2%. This is mostly due to allowance issues.
- Gross Direct Profit (Direct Margin) – This is the dollar value of the adjusted contract price less the actual direct costs of construction. These costs include land, materials, subcontractors, labor, and other direct costs (permits, insurance/bonds, engineering, site utilities etc.). See Best Format for a Construction Income Statement for a better understanding of this subject.
- Gross Indirect Profit (Gross Margin) – This equals the direct profit less the indirect costs of construction. Indirect costs are those costs associated with construction but cannot be directly assigned to a particular project. Examples include management, transportation, communications, workman’s compensation insurance, payroll taxes, equipment, tooling and supplies. It is important to understand that these types of costs are shared among the projects. A typical contractor will have at least three projects in progress. These types of costs generally run about 18 to 21% of total contract revenues.
- Business Profit (Gross Profit), Sometimes Referred to as the Net Profit – This is not the actual net profit of the company, it generally does not include the taxation deduction to the company or owners. If the owner has not included his compensation in either the indirect expenses or the overhead section, then this number should be referred to as the Gross Profit. The value is calculated by subtracting the overhead costs (office operations, marketing, and corporation fees) from the gross margin. For most small contractors, the overhead runs around 7% of contract revenues.
- Net Profit – This is the final number, no other deductions can reduce this number. In general this is the after tax costs. For most small businesses, a reasonable tax percentage to use is 23% to cover federal and state income taxes. Do not use the higher corporation tax rates or the lower individual rates; the best rate is generally the personal income rate plus about 2% plus state/local income taxes of 6%.
So why should the profit be 9%? Two factors contribute to this number. First is the necessary profit to reward the owner(s) for starting and assuming the responsibility of owning the company. A reasonable expectation of any business owner is 3 to 5%. If your typical small contractor has adjusted sales of $1,200,000 per year, then we are talking about $36,000 to $60,000 for owning the business. This assumes that the owner receives a compensation package in the indirect section of the financials. Think about this for a moment, somebody took a business risk, gave up security in another job, to walk away with $36,000 a year after taxes as the reward for taking this step. This is reasonable given the nature of the responsibilities.
The second factor in the profit percentage calculation is the risk element. In the real estate industry, there are cyclical periods between plenty of work and a low demand for new housing or restoration type work. This is mostly tied to the ability of the consumers to borrow money. In general, a small business contractor will have about 7 good years of work with 3 year of poor or low volume of work. During the slower periods, the contractor should endeavor to break even, in effect losing his $36,000 to $60,000 per year profit. So technically, this particular contractor will lose around $150,000 during the slower cycles. To make up for this he’ll need seven good years. In reality, of those seven years, only four will be really good to cover this risk factor. So a reasonable number to use is 5% because this will generate $240,000 to cover risks inherit in this industry. The best example of risk is what happened to real estate in 2008 and 2009.
When you combine both factors, it should be reasonable to expect 9% as a true after tax net profit.
This is where I get into the math of calculating the markup on the direct costs (materials, labor at cost, subcontractors and supplies). It may appear overwhelming, but please stick to the step by step process and you’ll understand the value. It is worth spending the one to two hours and walking through this formula so that you charge the appropriate amount for the work you do. Please do not work for free or for low profit. You would be better served to be an employee for another contractor. This is a risky business and you need to earn an appropriate and FAIR return for the risks you take.
Now, let’s use some math and work our way back to the markup number on a project to effectively collect a 9% net profit in the business. Believe it or not, it is best to work from the bottom line back up to the final markup value. This is how it is done.
Step 1: Recalculate the net profit into the gross profit.
Note that the gross profit is the percentage of the adjusted revenue to cover taxes and a net profit of 9%. Tax is 23% of gross. Therefore gross = (.23g + .09); therefore .77g = .09; then g=.09/.77 = .1169 or Gross Profit (sometimes referred to as Ordinary Income) = 11.69% of adjusted revenue.
Step 2: Adjust gross profit to gross margin to cover overhead expenses.
In general gross overhead is 7% of adjusted revenues. So this formula is straight forward, to get to gross margin, you need to add 7% to the gross profit percentage. Therefore, the gross margin should be 18.69% of adjusted revenues.
Step 3: Determine the direct margin percentage of adjusted revenues
This is a simple addition formula too. A contractor will need 21% of his adjusted revenues to cover these indirect costs. Think about this for a moment, if the contractor has $1,200,000 in adjusted revenue, then he’ll need around $252,000 to cover those costs. This may appear high, but in reality, the management cost assumes the contractor himself and some type of a project manager to turnover construction work valued at $1,200,000. For the contractor and the project manager, you will easily spend $160,000 for salaries. Add to this about $20,000 to $30,000 for payroll taxes and benefits for all field labor, and you can see that this easily absorbs $185,000 of the $252,000. This leaves around $67,000 to cover transportation costs (couple of trucks), cell phones, tooling, workman’s compensation insurance (easily in the $8,000 range), general liability insurance, and any equipment costs (generators, landscaping tractor, backhoe, trailer etc.). So 21% of the adjusted revenue to cover indirect costs is a good formula basis. With this in mind, we need 21% indirect costs plus 18.69% to cover profit, taxes, and overhead. Therefore, a contractor should have a direct margin of 39.69% or 40% to include a little fudge factor. The direct margin should be approximately 40% of adjusted revenues.
Step 4: Determine costs as a percentage of adjusted contract revenue.
If the direct margin is 40% of adjusted contract revenues, then the costs = 1-direct margin or 60%. Therefore, costs of construction (direct costs) should be 60% of the total adjusted contract revenues. Therefore, markup is calculated as follows: See Markup and Margin for a better understanding of this business concept.
Margin % = Markup% * Cost; therefore 40%=Markup * Cost (60%); therefore 40%/60% = Markup %; therefore Markup % = 67%.
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As a contractor, you will need to mark up costs 67% to cover all the other elements of the company’s expenses, taxes, and profit. This gets us back to the adjusted sales price. Therefore, the question is ‘what markup margin and markup do I need for the contracted sales price’? The answer is simple. The adjusted sales price is about 89% of the sales price. An 11% revenue adjustment is needed for both factors to determine the final margin for the contract and the markup.
For the contract margin, the needed 40% gross margin should have the 11% closing adjustments added to determine the approximate contract margin percentage. Total margin for a project to cover all the closing cost issues, indirect costs, overhead, taxes, and profit = 51%. Markup on costs = 51%/60% costs or 85% markup on costs to construct the house. For re-modelers, restoration and addition contractors, use 71% markup. So let’s walk through an example of a contract proposal.
You have been engaged to build a 2000 square foot home on a $35,000 piece of land. The $35,000 includes the purchase closing costs and tap fees etc. It is an all-inclusive price. You anticipate based on the buyers desires etc. that costs of construction (direct costs) will run about $42 square foot – see my sidebar above for an explanation of direct costs. Therefore, total costs of construction including land will equal $119,000. If the markup needed to cover all other costs is 85% of the costs, you will need to add $101,150 to the costs and therefore the contract price equals $220,150. This equates to $110.08 square foot fully loaded price including land. So, most contractors understand that this is a relatively simple and basic house.
Now let’s walk all the way through to the net profit (remember this should equal 9% of the adjusted revenues).
This happens to equal 7.72% of the contracted price.
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Based on the above information, you can mathematically see that even at an 85% markup on costs of construction, it will be tight to make a 9% profit on the adjusted contract price. You are really talking about a 7.75% overall profit on the contracted revenues. Again, review the risks involved in being a contractor, look at all the auxiliary costs via direct and overhead. It is apparent that even at 9% profit, this is a difficult business to own. In the model above, I assumed the contractor paid himself about $85,000 a year in a salary to get this profit. In effect, if you have contracted revenues of $1,348,300 ($1,200,000 divided by the adjusted contract % of .89) then you will earn a total of $225,280 before taxes. You should expect taxes of approximately $51,800 plus payroll withholding for Social Security and Medicare of $6,502. Therefore your final take home cash at year end equals $166,963. Remember this only happens in the best years of business, about 4 out 10 years of construction. There will be about three years of just your salary as the company will do its best to cover costs during this lean period. Finally, this take home amount covers owning the business, industry risk, and your management compensation. This is a tuff business to make a good profit. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.
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