So I think the better question is ‘What should be my margin?’ The answer to this question is ‘How much do you want to earn as a net bottom line profit?’ This is where it begins, not with revenue, not with project margins or even bottom line gross profit (before taxes); but the after tax net profit to reward the owners for their risk and add money to the working capital for future growth. Determine this value first.
Allow me to illustrate, how do you compare a $3,000,000 per year in revenues for a residential contractor to a small bridge builder doing government work with $70 Million per year in revenue? You can’t. Let’s walk through both and get an answer.
This one is actual relatively simple. In this guy’s case he wants a simple salary of $100,000 per year to take care of his family and believes he should net around $120,000 after taxes for his profit. In his thinking, he wants to take home $90,000 and reinvest $30,000 in his company. Simply stated he is interested in a NET AFTER TAX PROFIT OF 4% (120,000/3,000,000). His before tax profit at a tax rate of 29% (federal and state) means he needs a gross profit of $169,000 (($120,000/.71 (1-.29 tax rate)).
Knowing this, we need to continue working backwards to figure out project margins. Since he is a relatively small company, his front office consists of two full time clerks. They do the bookkeeping and processing of paperwork and deal with the phone calls. These two clerks cost him about $75,000 per year including their payroll taxes and benefits. His actual office operations (facilities, office supplies, taxes/licenses, banking, interest on debt etc.) cost another $37,000 per year (the office is a small place). So his entire front office costs $112,000.
If we add the required gross profit of $169,000 to the overhead costs of $112,000 we get a required construction margin of $281,000. So right now, the projects must generate no less than 9.37% to cover these two groups of required dollars.
But now let’s talk about the really confusing part for most of you reading this article. It is the indirect costs of construction. Basically when this guy builds a house he buys materials, uses subcontractors, pays wages to the business employees (field employees), pays for other directly assignable costs (dumpster, port-a-john, permits etc.). These are known as direct costs of construction. They are easy to identify and honestly, without these costs he can’t possible build the house.
The real problem lies in some of the other needed costs that are directly assignable to a house but can’t be due to their nature. Remember, he is most likely building three or four homes at a time in different stages. So he gets in his truck and checks on each job each day. Hmm…., there’s our first unassignable cost, his truck. These costs are referred to as indirect costs of construction and consist of the following:
- Project Management (includes the contractor’s salary, project manager salary and their corresponding payroll taxes)
- Communications (cell phones, radios, and if you still use them, Courier Pigeons – a little levity to the subject)
- Equipment (many residential contractors have generators, air compressors and tools, trailers and a backhoe)
For a typical residential contractor these costs will run close to $300,000. Yup, you read that correctly. Think about it for a moment, one truck will cost around $8,500 per year to operate including the truck payment, fuel, auto insurance, repairs and maintenance and the cost to mount the bobble head in the front dashboard.
Then there are the salaries, remember the owner wants $100,000 per year. You can figure the other project manager, the one that is onsite all the time costs $80,000 per year. Add to this their fringe benefits, taxes and you end up over $200,000 just for this one line item. So it isn’t unreasonable to think of $300,000 for these indirect costs.
Now we need the projects to generate $581,000 ($300,000 for indirect and $281,000 for the overhead and net profit) per year on $3,000,000 of revenue. This is a project margin of 19.37%.
It actually gets a lot worse because many residential types of contractors use a form of Adjusted Gross Sales Price in the contractual relationships with their customers. It is very similar to what happens when you buy a home. The original contract is for $200,000 but you will only sign if you get an allowance for any mortgage points and fronted costs. Well, the contractor does the same thing. Furthermore, just like any seller of real estate, he has closing costs. So in his case the revenue is adjusted to get net revenue, so in reality it follows this presentation format:
Now we have different relationship. His actual net sales are only $2,691,543 and he needs a contribution margin (net sales less direct costs of construction) of $581,000. So his required project margin is actually 21.59%. For those of you wondering, this means that a markup on direct costs must be 27.53 percent.
This is the markup on direct costs just to get a 4% net profit after taxes. If you want 9%, then the markup is nearly 35% (not 32.5 like some of you may think because the additional 5% is after taxes which means you need to add a little more than 7% to the 27.53%).
What is important to understand here is that this doesn’t account for economic cycle risks, personal risks and capital costs. So for a residential contractor, you need a contribution margin of at least 25% to end up with a fair and reasonable profit of four to seven percent. This means markups on direct costs are from 30 to 33% to get a contribution margin on net sales of 25%.
And this is for a $3,000,000 a year residential contractor.
Does this ratio hold true for a large builder of some sort? Let’s find out.
Just like the residential builder, the owners of this company want a profit. They desire around $850,000 as the after tax profit. Assuming the tax rate is around 39%, the gross profit (net profit and taxes) will need to be $1,394,000.
With this kind of business the front office costs go way up in comparison to the residential contractor. In the front office the company has 12 staff involved. There’s an officer manager, controller, finance director, two engineers, an accountant, two support staff and four project estimators/buyers. Furthermore the office operation is much more complex than the residential contractor and when it is all said and done, the costs for the front office are a tad over $1,900,000.
So total margin needed to cover a NET PROFIT, income taxes and front office is $3,294,000. This is 4.71% of total revenue. Notice up in the residential contractor formula, this same margin point is 9.37%. This is a big difference in terms of percentage. Don’t forget there is a huge difference between a $3,000,000 business and a $70,000,000 operation.
The counter side to all of this relates to the indirect costs. In this form of construction industry the indirect costs as a percentage of contract revenues is actually greater. Think about it for a moment, the knowledge base in the form of project managers, on site engineers, surveyors and quality control is much more expensive per man hour than a guy building houses. The risk factor is significantly greater therefore the overall indirect costs are going to be significantly greater. The equipment line alone will dominate the indirect costs section. Bridge builders don’t buy $2,000 generators; they buy generators that are mounted to trailers. Add in bulldozers and cranes and now you can see the indirect costs soaring.
The offset to this is that often the accounting mechanism is different here in that the government requires a cost allocation model that must be followed whereby the indirect costs are assigned to the project using some formula. In effect, the definition for direct costs of construction is different in government contract work than in your private residential construction work. Here direct costs include an indirect cost allocation line of information.
Since most of the indirect costs are assigned via formulas to jobs, the indirect section of the financial report will actually become a small number as a percentage of the revenue. Basically the direct costs of construction gets greater as a ratio of revenue as the construction venue goes from residential to complicated highly engineered structures. To further complicate matters, in these types of contracts there are no allowances or closing costs that mimic the percentage found in residential contracts. So at the end of the day, the project margin as a percentage is significantly less than that associated with a residential contractor.
Think of this as something similar to an economy of scale. Therefore for large contractors like this, the project margins are in the nine to twelve percent range. This is due to the fact that much of the construction indirect costs are assigned to the project reducing indirect costs as a percentage of revenue.
What is really annoying about all this is the misinformation found in the so called databases of information.
Apples and Oranges
In my research for this article I came across many different sources and each had some far fetching analysis. As an example in one report about road builders, the average overhead costs ranged between eight and seventeen percent. One big range if you ask me. I would imagine that some of the data sources included their management team in their overhead analysis while others assigned the project managers to the respective jobs. So you really can’t compare because one is conveying their information like an apple while another believes the orange method of accounting is more appropriate.
To me if you want to know what is the correct margin in your construction business, you would need to get together with about 20 other similar sized contractors throughout the United States and then create a set of standards for terminology and agree what is overhead, what is indirect and what are direct costs. Then compare and analyze. By the way, this is known as a focus group in business.
In the interim, follow my suggestion and determine a net profit after taxes value. From here, reverse engineer the before tax amount, add in overhead (office operations) and determine your overall indirect costs of construction.
By the way, the indirect costs of construction are the most expensive aspect of your business. Control this group of costs and you will generate real profitability via better estimates and reducing overall risks.
Once you have these three values (profit, office operations and indirect costs) you can now establish the markup on direct costs to achieve success in business. 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 help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.