This article will start out by covering some of the terms used and then explain the issues remodelers face. I’ll finish up by walking you through a basic example and establish a range of markup related to remodeling.
Before I list a few terms and their definitions related to this subject, if you are not aware of how markup is calculated then please read What is the Difference Between Markup and Margin. This article explains in detail the respective definitions and the proper perspective. Simply stated markup is the percentage of cost that is added to the cost item and margin is generally expressed in the form of dollars or as a percentage of the revenue generated from the sale of the item. Allow me to illustrate with a simple example:
Beverly owns a tile retail center. She buys the tile for $1.21 each. She marks up her tile 40% to cover her overhead and profit desired. Her markup is 40% of $1.21 or 48 cents. So she sells her tile for $1.69 each which is $1.21 for the original cost and 48 cents to cover overhead and profit. When she sells the tile she generates a 48 cents gross profit. Her margin is 48 cents on $1.69 or 28% of sales.
Markup is a function of cost; Margin is a function of sales price.
So the concept is focused on the term cost. So what are your costs?
It fascinates me how contractors define costs. I swear you could ask 50 contractors to define the term and you’ll 65 different answers. They don’t understand what the term truly refers to in construction. Let’s just use labor as an example. I’m talking about the $12 an hour guy that you place on the job site to do the manual labor. What is his cost? Immediately many of you will answer $12. Well in reality he costs a lot more than $12 an hour. Let’s see how:
- All of us know that you have to match his Social Security and Medicare taxes. This is the employer matching requirement under the Federal Code. In this guy’s case it is 92 cents.
- Not only must you match his Social Security and Medicare, you also have to pay for federal and state unemployment taxes. This varies from state to state. For my example here I’m going to use 38 cents.
- Now let’s talk insurance. The minimum insurance for him is called Worker’s Compensation. This too varies from state to state, job duties and has some connection to your safety record. For this example I’m going to use 55 cents for that one hour of work.
- Now that you have covered the very basics of an hourly wage employee, are there other costs associated with him? Most likely yes. Do you offer some form of retirement match? How about any health insurance subsidy? Do you provide any time off with pay? Holidays? How about a Christmas bonus? Do you buy pizza every now and then for the guys on the job site? All of these are direct costs of labor tied to the hourly wage through a pool of costs.
In the aggregate, this employee easily costs $13.85 plus whatever benefits you provide.
This is why it is so difficult to identify the true direct costs of construction. Most businesses pool these additional costs beyond the hourly wage and cover these costs with the markup percentage. I encourage you to do the same. But my primary goal here is for you to realize that a part of that markup is covering these additional labor costs.
There are also material costs that go beyond just the 89 cents for the 2X4. There’s the sales tax, delivery charge, account surcharge and more.
Beyond your standard three core costs of materials, labor and subcontractors there are still many more costs to get the job done. Other costs include:
- Debris removal
- Site Information Posting (signage, containers etc.)
- Environmental Fence
- Equipment usage
- Fuel for Pumps, Generators, Air Compressor
- Lost/Stolen Tools
Almost every one of these costs can be directly tied to the project itself. But what about those SHARED costs such as transportation, communications, general liability insurance and project management. The typical remodeler runs more than just one job at a time. So he drives between jobs throughout each day. What about the costs for that truck? There’s gas, the truck payment, auto insurance, maintenance and repair and more. These types of costs are referred to as indirect, i.e. that cannot be directly assigned to any one particular job; they are shared among several jobs. So how do we account for these costs?
The answer is similar to the labor issue described above. The markup is designed to cover these indirect costs.
For those remodelers that I have provided services to in the past I modify their Profit and Loss Statement to reflect three major groups of costs. The first group is the direct costs of construction. These are the actual cost of materials, labor, subcontractors and the other costs to remodel the home. Any cost that can be directly tied to the project is considered a direct cost. So that bill received from Home Depot for the materials is direct cost and that bill will include the sales tax and the delivery charge too. For labor, I typically focus on two directly assignable lines of cost. The hourly wage paid to this employee and the matching taxes (Social Security and Medicare). The other employee taxes and benefits are assigned to the next group called INDIRECT COSTS.
As explained above in the direct costs section, those costs that are shared among several projects such as transportation and communications are line items in the indirect group of costs on the Profit and Loss Statement.
The final group of costs is overhead and refers to the costs back at the office. These costs include rent, office wages paid, utilities, office supplies and so on.
A well formatted Profit and Loss Statement for a contractor will look something like this:
Profit and Loss Statement
Period Ending MM/DD/YYYY
Completed Contract Method or Percentage of Completion Method
Contract Revenues $ZZZ,ZZZ
Change Orders/Allowances/Addendums ZZ,ZZZ
Interest Earned on Contract Revenues ZZZ
Total Construction Revenues $ZZZ,ZZZ
Sub-Total Direct Costs ZZZ,ZZZ
Direct Margin $ ZZ,ZZZ
Payroll Taxes and Benefits Z,ZZZ
Insurance (WC, General, Bonds) Z,ZZZ
Tooling & Supplies ZZZ
Sub-Total Indirect Costs ZZ,ZZZ
Gross Margin ZZ,ZZZ
Rent (office rent, storage etc.) ZZZZ
Office Staff Payroll & Taxes Z,ZZZ
Office Operations (Supplies/Postage/Printing ZZZ
Sub-Total Overhead Z,ZZZ
Net Profit $Z,ZZZ
Notice the three distinct groups?
Markup is designed to cover the costs associated with indirect costs, overhead and the profit.
My experience has taught me that for most contractors the minimum indirect costs of construction run 23%. What happens is that this percentage decreases as a percentage of revenue as the contracts get higher in dollar values. So your new home contractor needs around 23% to cover these indirect costs. Your remodeler, renovation, and restoration contractors need higher markups because the percentage of indirect costs increase due to the nature of the math. Let’s go back to the tile example from above. Beverly needs 48 cents on each tile sold to cover her overhead and profit. Well, if the price of tile goes from $1.21 in costs to $1.78 in cost similar to how remodeling goes from $35,000 job costs to $325,000 in job costs for a new home contract; what happens to the markup percentage?
In the example above, Beverly’s markup on cost is 40%. What is the markup on $1.78? It is 27%. So as the contract costs begin to go up, the markup percentage begins to drop.
In remodeling the markup to cover the indirect expenses will range between 35 and 85%. This is more realistic given the nature of the various issues you must address.
Issues Remodelers Face That Drive Indirect Costs Higher
Remember I said that indirect costs are generally higher dollar for dollar of direct costs for remodelers over other forms of contractors? Why is this so? Well, the most common indirect cost is the project management which is most often the salaries for you and the other project managers. Think about it for a moment, you are onsite more often and for longer periods of time because of the complexity involved in remodeling over new home construction.
The following is a short list of what drives the time requirements for all involved:
- The homeowner still lives at the house! This is the most demanding time issue for project management; dealing with the homeowner, moving furniture, trying to maintain cleanliness and safety and more.
- The remodeling project requires more time to tie in the existing features of the home to the project. Think about the additional time it takes just to get the paint to match. The new home contractor doesn’t have this problem.
- Matching of materials to the existing home items. Something as simple as the baseboard. If the existing baseboard in the house is more than 40 years old, odds are that you will have to have the new baseboard custom made to match.
This additional time requires more indirect costs to address these various issues. There are a couple of more issues and I want to drive these two points as major indirect cost drivers for remodelers.
- Insurance is generally higher for remodelers than new home contractors. For new home contractors they will purchase a single rider for just that project. This means that the project has a direct cost associated with its construction. That cost is assigned to that project and therefore the indirect costs as a percentage can be lower. In remodeling and in the additions industry, the insurance policy is generic and therefore this cost is included in the indirect costs section of the Profit and Loss Statement.
- Those contractors involved in the remodeling, additions and restoration services have to spend more time generating deals than your new home contractors. Since deals in the remodeling industry range between $10,000 and $100,000 a remodeling contractor has to quote several deals to garner the same volume of dollars as one new home contract value. This drives indirect costs with greater transportation needs, more project management time as a ratio of total dedicated to estimating and so on.
So overall; indirect costs of remodeling are significantly higher dollar for dollar on direct costs of construction in comparison to new home or commercial construction. Don’t forget, you must also add markup to cover overhead and a desired profit. The following section illustrates a simple formula to determine the correct markup on remodeling work.
For your formula to work you must know four values. The first is the desired profit. The second value you need is the expected total of overhead costs. For your smaller remodelers having one person in the office you should expect to pay out around $55,000 to $65,000 per year in overhead. The third value is the total of indirect costs.
The best indicator of these respective values is your historical accounting information. The more information you have the more accurate you will be in determining markup on your costs.
The final value is the approximate volume of contract work in the upcoming year. This is an element of the formula. So let’s begin with our values. The following are my examples of overall values:
- The profit desired is $135,000 and includes my compensation package, e.g. wages, benefits etc.
- My overhead is $57,000 and includes one office worker and a small office with some garage storage included.
- My indirect costs comprise $142,000 mostly tied to one field manager (paid $65,000), two trucks and one working van, insurance, 4 cell phones and some equipment. The total indirect costs include the benefits package for 6 employees (4 field workers, 1 manager and 1 office worker).
- I estimate that the business will complete 28 projects for a total of $1,050,000 in contract revenue.
How much markup is required?
Step One: add all the costs together and create one value.
Indirect Costs 142,000
Total Required Cash $334,000
Step Two: subtract total costs from expected contract revenue to get direct costs of construction.
Contract Revenue $1,050,000
Required Cash 334,000
Direct Costs of Construction $716,000
Step Three: using the formula from above, calculate markup needed on direct costs.
Required Cash $334,000 Divided by Direct Costs of $716,000
Markup on Cost is 46.65 percent or 47% for rounding
This is actually a pretty low markup. In reality I need to generate more than just the $135,000 of profit. Technically from that profit I’ll net around $85,000 and this isn’t enough to take home as income to my family and put enough money away for future issues related to the business. A more realistic value is $175,000 so I can reserve around $25,000 for future needs or emergencies. If this is true, then my total required cash will be $40,000 higher and my direct costs will be $40,000 lower (remember I’m not changing the revenue value). So now my formula changes to $374,000 divided by $676,000 of direct costs. My markup should be 55.33%.
Notice the impact on markup with a small change in needed cash to cover any expense related to indirect costs, overhead or desired profit. This is how sensitive the formula is to change.
For your average remodeler, markups range from 35% to as high as 85%. This is dependent on the volume of work you do in the field. As the volume increases the overall markup percentage goes down because you are covering the required needed cash with more dollars. Therefore the ratio decreases.
For those of you performing really small jobs such as decks or bathrooms, the markup is going to tend towards the 70 and 80 percent range. Those of you doing the large interior remodeling and additions, you can get markups down into the 40 to 50% range. But remember, the markup is on the direct costs of construction and you need to decide which ancillary costs (remember my labor example from above) are included and excluded from direct costs. 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.