To answer the question, first, let’s understand that there are 3 levels of performance and each level has a minimum standard of profit to a maximum profit. Once you understand these three levels, it is then important to understand the economic cycle and its impact on this standard of profitability for your company. Finally, every contractor needs to understand that this profit is different depending on the nature of your service. Those involved in the restoration aspect of residential construction are going to have a different profit standard grouping than new home construction. So it isn’t necessarily equal across the board for all areas of residential construction. Remember, there is risk reward involved here and therefore, the profitability standard shifts depending on the risk involved. To help you understand, let’s begin with the three standard groups of profit.
Three Standard Groups of Profitability
The Internal Revenue Service uses a tiered system to evaluate businesses in the same business sector. When a tax return is prepared, the accountant inserts a principal business activity code which tells the IRS what business sector and industry within that sector the company renders its activity. So all residential construction companies building new homes enter a code number 236110. All returns filed with that code is compiled to create standards of performance. In effect, the top 20% set the standard that the balance of the group is compared against. Those in the lower 20% are the potential red flag entities and are highly susceptible to an audit.
The 60% in between, are considered normal. It’s this top 20% where you want your company to perform. After all, making a profit is what it is all about. If you want to not pay taxes, that is easy to solve; simply have me do your accounting in December of each year, I’ll determine your profit, you write the profit check to me for services rendered, I’ll pay the taxes and you’ll have no taxes to pay as my fee is deductible. Thus zero profit and of course zero taxes. But business isn’t solely about how much tax you pay, it’s about profitability. YOU WANT TO PAY TAXES, IT MEANS YOU ARE MAKING MONEY!
Getting back on track here, there are standard groups of profitability.
- The upper 20% (where you want to be)
- Normal (those from 20% to 80% in performance)
- The lower 20% (you have serious problems in this group)
Now let’s get to the nitty-gritty. Here are the expected profits for each of the three groups. This assumes that it is a normal year and the industry is not experiencing a recession nor significant growth which rarely happens. The home construction industry is either in full swing or is experiencing setbacks usually tied to the ability of buyers to obtain credit in the market.
Upper 20% – Profits are 5.5% or more; those with profits of 7.7% are in the upper 97% of performance.
Normal 60% – Profits range from 2.8% to 5.5%.
Lower 20% – Profits do not exceed 2.8% and most are often negative, i.e. losses are being sustained by the contractor.
- It is a normal and reasonable year without unusual or infrequent events.
- The method of accounting (completed or percentage of completion) is properly documented; those using the completed contract method have enough volume of activity to negate timing issues related to recording revenue and associated costs.
- Market conditions and availability of credit are normal.
- The owner pays himself at least $100,000 per year via the payroll which is a deduction before the net profit is calculated. The owner’s compensation as an employee is not included in the net profit; it is calculated above the bottom line.
Next, understand that the profit is the ratio of actual dollars earned against total sales. A typical residential construction sale is the contract value plus all associated change orders, upgrades and allowance adjustments. The profit is not evaluated against net sales which typically is total sales adjusted for closing costs and contract allowances.
Finally, there is the question related to income taxes. A legitimate financial statement usually includes income taxes as a deduction before determining net profit. Most folks don’t do this because their tax status is usually some form of a flow through entity such as a limited liability company or an S-Corporation. So if your company prepares its financial report excluding taxation, then you will need to adjust the grouping standards by 25%. Therefore, if your company reports its information for tax purposes and issues a K-1 to the owner, then the profitability groupings are as follows:
- Upper 20% – Profits are 7.3% or higher, the best are earning more than 10.2% net profit
- Normal – 3% to 7.3%
- Lower 20% – Less than 3% net profit
Again, the above table is for flow through entities which most small contractors operate as in this industry.
Take note, if your company has sales of $6,400,000 per year and you are operating as a typical S-Corporation, then your net profit should be $467,200 to state that your are one of the best out there. If not, you are doing something wrong!
Naturally, the above assumes that it is a normal year. In this business industry, there is no such thing.
Economic Cycle Impact
Residential construction is tied directly to the real estate economic cycle. That cycle goes through three phases over a course of 11 to 13 years. It will experience three to six years of growth, about two to four years of stable activity and about three to four years of decline. During the declining years, the entire industry experiences retrenchment whereby new construction is slowed dramatically (more than 20%). Most of the poor performing years are directly related to the ability of consumers to acquire credit to purchase new homes. During the growth period, new home construction experiences accelerated growth as new home construction permits are issued at higher rates. During 2016, 2017 and year to date in 2018, the industry is experiencing expansion. There are signs indicating that 2019 will slow, possibly maintain the current levels but it is clear that we will experience a few years of stable conditions. The most recent decline started back in 2008, so the current cycle looks it will run around 13 to 15 years in duration. From 2008 through 2013, the industry experienced a drawback in new home construction and the growth period started around 2014 and is in full swing right now. The strongest economic indicator of slowing down is of course the increase in interest rates as controlled by the Federal Reserve.
Using this current cycle as an example of how profits should flow, a typical residential contractor would experience something comparable to this schedule:
- From 2008 through 2011 – significant losses on their financial statements; losses of 3 to 5% would be expected for normal (that 60% group) operations. Note that those in the upper 20% would experience small losses to some profitability, but breakeven is considered performing well.
- From 2011 through 2013 – the normal group would breakeven and possibly earn a small profit.
- From 2014 through 2018 – these are good years and a normal operation should earn maximum profits.
- 2018 for several years – stable conditions warrant average profits
The standards laid out in the first section above reflect the average over the entire economic cycle. Therefore, in the really good years, your operation should be earning significantly more as a percentage and in volume of revenue to compensate for the those underperforming periods of time. During the downturn in the cycle, profits will be pretty much non-existent and overall revenue will be down in comparison. The end result should be 7% on average (pass-through types of entities) throughout the entire economic cycle.
Profitability is not only effected by the economic cycle, it is also highly dependent on which sub industry of residential construction your company is currently operating within. Remember the risk/reward tenet of business.
Risk/Reward Relationship in Residential Construction
One of the primary tenets of business is the saying ‘As risk increases, so should the reward’. This simply means that when an owner takes on more risk, his reward via profits should be higher to compensate him for that risk. The economic cycle and its associated risk were discussed above. This section will explain the risks involved with residential contractors. Not all residential contractors are the same. There are generally five types of residential contractors as explained below.
- Restoration Contractors – this particular residential construction sub industry addresses repairs to homes due to storm, water and fire losses. Here, the relationship is actually a three-way interaction between the contractor, the homeowner and the insurance company (the one writing the check).
- Remodelers – this sub industry provides additions and standard kitchen/bathroom remodeling. Most jobs are less than $50,000 each and the turn around time is less than 90 days per project.
- Custom Home Builders – the core of the residential construction industry occurs with this type of contractor. Here, he builds a custom home either under a contract with the home buyer or via specifications and the house is placed on the market for sale.
- Developers – basically developers are an expanded customer home builder, but often site work is required expanding the scope of services provided.
- Group Housing – some companies are involved in group housing construction such as apartments, condos, townhouses, and/or group housing. This type of builder borders on the commercial level of construction, but since it is still involved in providing housing, it is still within the residential construction industry.
As you look at the groupings of contractors, notice how they range from smaller jobs to much larger more complicated aspects of residential construction. This size/complication aspect of this industry is considered a risk factor. Think about the remodeler for a moment, a remodeling job doesn’t require high skilled labor or engineering work which is customary with custom home builders. There is also the associated potential loss related to the work. As the jobs become more expensive, the risk of market change and thus the corresponding potential loss increases. Those involved in group housing are easily affected by local economics (a large employer could move) thus affecting the market value of the project.
Given these risk factors, it is reasonable to expect the group housing contractor to earn a greater profit than the restoration contractor. After all, his risk is higher and therefore the reward should be greater. How much greater? Well its a percentage of the standard formula. The standard groupings I identified above relate to the custom home builder. Those contractors in the less riskier sub industries should see profits about 25% less on average while those involved in group housing should see profits 25% higher. The table below illustrates this well. You may click on the link to open in a separate window.
Take note of the following:
- Normal year and reasonable volume of contracts completed and sold
- The economic cycle is stable
- This assumes you are a custom home builder
So where are you in the table?
If you are not in the top 20%, then you are doing something wrong. I encourage you to contact me and let me identify the issues you have and how to address them. Typically, it takes about a year to get it all straighten out. Most of the hard work is done during the first three months and the balance of the time is just monitoring and following up on the work. But time is necessary to confirm the results. Nothing good happens overnight, it is a long and involved process. Go to the ‘My Services’ page in the footer below and contact me. ACT ON KNOWLEDGE.