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Contractor’s Profitability

Resolution of Misunderstanding Between the Contractor and Homeowner Related to Profit

I’m surprised at how many visitors to this section of the website are oriented to what is a fair profit for a contractor.  I’m not referring to the industrial or the commercial contractor; I’m referring to your standard residential contractor. To resolve this, I’m going to approach this from two perspectives.  The first is the homeowner’s perception and then the reality.  Both sides of this equation should learn from this, IT COSTS A LOT MORE THAN YOU THINK TO BUILD A HOUSE!

Homeowner’s Perspective

To the homeowner, this is simple.  What is the cost of the material, the cost to install and yes, you are entitled to a fair profitFor the average homeowner, he believes that you should have a profit of 9 – 15%.  I can accept this as a fair profit.  The question is ‘What are we multiplying as the base to determine this profit’?  This is where the two perspectives go awry.

To the homeowner, it is merely a three step process.  One, buy the materials, two, install the materials, three, send me a bill.  OK, that is fair in thinking so let’s see how this turns out with a simple 2X4 (for those of you that don’t know, this is read as ‘2 BY 4 – 2 inches wide by 4 inches wide –  which is the standard piece of lumber for a wall stud) installed.

OK, contractor goes down to Lowe’s and buys the 2X4 for 99 cents.  Contractor goes back to the house and installs the 2X4 in about 15 minutes.  What is a fair price for labor?  Well to the homeowner, $15 to $20 per hour seems fair.  OK, 15 minutes equals ¼ of hour at $20 hour, so this equals $5.  So here is the homeowner’s math:

Materials Cost                           .99
Labor                                       5.00
Total                                        5.99
Profit @ 12%                            .72
Total Amount Due               $6.71

Notice the three steps, materials, install and bill the customer.

Now let’s look at the reality of the situation and what it really costs the contractor and what he should make as a profit for the exact same step.

Reality

It is the same job.  But before we go to Lowe’s to pick up that 2 X 4, we actually had to take a few preliminary steps.

First off, the contractor gets a phone call from a potential customer, for sake of argument, that’s one penny.  But even before the phone call, the customer has to find the contractor which means in the old days, the phone book.  In more modern time, it’s through the internet.  Well, both methods cost money to get done.  The old method of the phone book ran about $10 a phone call in advertising.  Typically a small contractor paid about $450 per month for advertising in the phone book.  He would get around 50 to 60 calls per month from the phone book, but only close on about 7 calls.  This means an actual paying job costs about $64 each in advertising.  Well, that price is a little lower with modern technology as the most expensive aspect of a website is the initial set-up.  Then it’s the amount of time to continue maintaining the site.  This is in addition to the monthly hosting cost for the site.  So for sake of simplicity, let’s just use $50 for the referral from the internet.  Now onto the phone call.

They talk for a bit about the problem and its relatively simple, there’s a stud missing in my wall the homeowner says.  Now, if you are homeowner reading this article, envision the contractor, what is happening is the contractor is rolling his eyes.  Because I’ve been there and seen this dozens of times, the homeowner says one thing and the reality is totally different.  So in response, all contractors say the exact same thing: “I need to take a look at the problem to give you an estimate”.

I’ll tell you a related story, now I’m just an accountant but I had to do some estimates for more complicated jobs due to the risk factor involved when I worked as a controller for a restoration company.  Got a call from an elderly lady and she needed her vanity replaced in her bathroom, nothing fancy; she was thinking $350.  I immediately told her it will be more expensive but I can’t say because I need to see it to estimate the job.  Her house was on my way home so I volunteered to take a look on my home that evening.  Turns out it was a vanity alright.  Apparently the toilet overflowed about 30 times too much and the vanity is made out of pressboard, the base had pretty much evaporated. 

It took me 5 minutes just to reach the bathroom due to the mounds of newspapers etc.  It turns out as people age, they hoard everything.  The dogs and cats didn’t help either.  Got to the bathroom, come to realize this house is not a house, but a trailer permanently mounted on blocks.  Trailer bathrooms are about the size of a miniature closet.  Lowes doesn’t sell bathroom fixtures for trailers.  Neither does Home Depot or any hardware store. 

I explained to her that it would have to be custom made and I would need to put in some floor framing underneath in order to properly support the vanity.  Since cabinet makers don’t trust contractors with measurements he would have to come out and measure the job.  Worse yet, the plumber would have to remove the fixtures and tubing (trailers don’t have traditional plumbing; they run tubes for water lines).  To aggravate this even more, the fixture had an electrical receptacle (the old two prong type) built into the vanity which means an electrician.

Altogether, I told her there was no way we could do this job for less than $1,400.  She is on fixed income and of course my estimate shocked her to utter disbelief.  She called me every name in the book and then some.  That was a rough evening.

The point of the story is that contractors investigate the situation first before giving an estimate or even conferring with the customer.

Now back to our situation with the one stud missing.  The two made arrangements for the contractor to come out the next evening to write up an estimate.  Now, think about this for a moment, the contractor is going out after work to do an estimate.  It takes a total of one hour to drive there and back and provide the estimate.  In reality, there is a lot more to this but usually jobs are significantly greater in workload. 

Alright, for the contractor’s time to estimate and drive, let’s call it $35.  Cost per mile for the vehicle at the IRS rate of .57 cents per mile for 10 miles there and 10 miles back is another $11.40 (20 miles times .57/each mile).  You can already see that this job is going to cost way more than $6.71.

Now, here is the only point that both the customer and the contractor will agree upon.  That’s the cost of the stud!  This is because this is the only piece of public information.  Here’s the contractor’s detailed estimate that stays in house (not presented to the customer):

Direct Costs:
Materials
    1 – 2X4 Grade 2 Lumber                      .99
   2 – 2X4 Flat Brackets (.76 each)          1.52
   8 – 12d Nails                                         .39
   Sub-Total Materials                                     2.90
Building Permit                                             42.00

Labor

  • Contractor’s time for estimate ($35), Pulling permit ($40), Inspection of work ($22), Phone call to call in county inspection ($7), Return trip to house to confirm county inspection ($35), Collection of check from customer and final discussion ($18) – Total $157
  • Laborer to drive to Lowe’s to purchase the stud, drive to home and set-up cutting station, mount the permit, cut the stud to the proper length, mount brackets, mount the stud, clean up and drive back to the shop: Total about 1.5 hrs at $17 hour = $25.50
  • Front office manager to prepare the invoice, record the accounting information and input the job costing information along w/managing the timesheets for labor – $6

Sub-Total Direct Labor                                           $188.50
Indirect Costs:
Payroll Taxes/Benefits (T/B)
    SS/Medicare Matching @7.65%                 14.42
    FUTA/SUTA @ 1.8%                                  3.39
   Simple Plan Contribution @ 2%                     3.77
   Health Insurance Subsidy @ 5%                    9.43
    Sub-Total Payroll Taxes/Benefits                             31.01
Transportation (covers gas, repairs & maintenance, depreciation, auto insurance, auto taxes, registration)
    Initial Estimate (20 Miles)                          11.40
    Pull Permit (24 Miles)                                13.68 *Permit mounted when laborer installed the stud.
   Purchase Mts (4 Miles)                                 2.28
   To Job Site (12 Miles)                                   6.84
   To Shop (10 Miles)                                        5.70
   Confirmation of Inspection (20 Miles)           11.40
   Collection (20 Miles)                                    11.40
   Sub-Total Transportation                                           49.02
Insurance
   Workers Compensation @6%                       11.31
   Errors & Omissions                                       1.22
   General Liability                                           1.90
    Property                                                         .22
   Sub-Total Insurance                                                  14.65
Supplies & Tooling                                                          .07 (Wear & Tear on Cutting Blade, use of Nail Gun)
Allocation of Overhead @16% of Direct Costs             37.34
Sales Tax on Materials                                                    .17

Summation
Materials                 2.90
Sales Tax                   .17
Building Permit     42.00
Labor                   188.50
Payroll T/B            31.01
Transportation       49.02
Insurance               14.65
Supplies                     .07
Overhead               37.65 (covers advertising, communications, licensing, revenue tax, rent, technology, professional services, postage, office supplies etc.)
Sub-Total                        $365.97
Profit @13%                       47.58
Total Bid                         $413.55 

In the final estimate to the customer, they usually see four lines – FOUR LINE METHOD of information:

Materials                          3.07
Permit                             42.00
Labor                            188.50
Overhead & Profit        179.98 *77% markup on direct costs
Total                            $413.55

Invariably, they understand the first three lines; it’s the fourth line that they perceive as pure profit.  This is where the disparity begins.

Reconciliation of the Disparity

Remember the homeowner is expecting $6.71 as the bid.  Why such a discrepancy?  The answer is simple, the homeowner limits his thinking to just the job itself and not all of the business aspects of what is truly involved.    In other industries, the presentation format to the customer is different and all the business dynamics are built into the quote.  For example in the auto industry, this is what the customer would see as his auto repair quote:

Materials                               $44.90
Labor (5.7 Hrs @ 77.00/ea)  438.90
Sub-Total                              483.80
Sales Tax                                    .17
Total Due                           $483.97

Nine times out of ten, the customer wouldn’t blink an eye at paying $77 an hour for a mechanic.  But for some reason, paying more than $17 hour for a carpenter is sinful!  This includes the amount he wants to pay for the contractor’s time too.  To the homeowner, you are nothing more than a glorified carpenter.  They don’t understand that you have years and years of experience, you took an exam, you have to maintain a license and run a business all at the same time.  On top of all that, many customers pay their invoices late and you have to deal with that stress!

This is the real crux of the matter for all contractors.  The profession is tainted as unknowledgeable and uncaring in delivery of service.  So the homeowner perceives the value as significantly less.

If the estimate to the customer were presented differently, you will most likely get a different reception.  Let’s review this presentation format:

Materials                                             2.90
Labor:
    Contractor 4.2 Hrs@ 77.00/ea     323.40
    Laborer 1.5 @ 30.00/ea                 45.00
Permit                                                42.00
Sub-Total                                         413.30
Sales Tax                                                .17
Total Estimate                               $413.47

Which presentation format works better?  In the eyes of the homeowner he now can see that you as the contractor will invest a lot of time and the laborer is relatively valued appropriately.  Again, remind the homeowner of what is involved in your time and that it isn’t unreasonable to pay that amount for someone with experience.  The $30 an hour for the laborer covers his basic gross wage, the associated taxes, benefits, insurance and transportation.  Use the mechanic as the defense for the fee structure.  Seriously, the mechanic goes to a class and suddenly he’s an expert; you on the other hand had to grind it out for more than 10 years just to get a little respect for your knowledge.

For those of you as homeowners, you need to realize that running a construction company is just like any other business.  There is a lot involved.  The overhead costs and the real cost of finding carpenters that actually know what to do is tuff. Most applicants for an opening are either alcoholics, drug addicts or have a slew of legal issues.  So it takes 100’s of applicants to finally hire a decent human being to be a carpenter.  Your better carpenters have about 10 years of experience and are in the late 20’s and early 30’s.  Just like everyone else, they have families and they deserve a decent wage for their services.  So please don’t expect to pay $6.71 for a stud.  The reality is that there is lot of work involved in generating an estimate and getting the job done right and legally!

Yes, you can find a guy out there that will do it for $100.  You better pray that he doesn’t hurt himself at your home.  The legal fees alone will almost build an addition to your house.  The key that identifies the legitimate contractor from the illegal guy is the issue related to the deposit or money down for materials.   The legitimate contractor asks for a small down payment like 5% or 10% of the contract.  Then he stipulates in the contract that upon delivery of the first load of materials to your driveway, he requires 25 – 33% payment.  This is normal in this industry. 

The shady contractor wants his 25 – 33% up front to purchase the materials.  What he is saying is:  I DON’T HAVE AN ACCOUNT WITH THE MATERIALS SUPPLIER AND I NEED YOUR MONEY TO PAY FOR THE MATERIALS UPFRONT.  Avoid this guy like the plague.  You’ll never see him again once you write that check.  Good practice in this business is a small deposit and a substantial payment upon delivery of material to your driveway.

Do this the right way and hire a legitimate contractor that comes with referrals.  It isn’t going to be cheap but you need to understand contractors face a deluge of costs to do what they do best.  If you are OK with paying more than $70 an hour for a mechanic, then you should be OK with paying a contractor a similar price per hour of service.  It is that simple.

For those of you that are contractors, look at my formula in the final estimate under the old four line method.  If you look at the overhead and profit, it’s 77% ($180/$234 of actual costs) markup.  Please do not confuse markup with margin, margin is different. 

I wrote an article called What is a Reasonable Profit in Construction?  If you read this article, I advocate markups in the neighborhood of 73% to 85% on direct costs.  The above example illustrates that thought pattern.  Naturally as the project gets larger in size, the markup can be reduced some (economy of scale), but in reality, you need  to have no less than 70% markup to generate enough money to cover all the respective costs associated with getting the job done and generating a profit of about 9%.

Furthermore, I have written a series of articles related to the various factors that affect profitability in business.  Read these for more guidance:

This article illustrates the thought pattern of the homeowner and the reality of how much it really costs to perform a residential construction job.  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.  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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About David J Hoare (389 Articles)
I spent 12 Years as a Certified Public Accountant, Over 20 Years of Practice in Accounting and Consulting, Controller in Management of Closely Held Operations, Masters of Science in Accounting, Prepared over 1,000 Business Tax Returns and Hundreds of Individual Returns