Minimum Bottom Line Profit Should Average 9.4%!
For Trades & Subcontractors, at Least 11%
After Income Taxes Are Paid!
No other aspect of construction impacts the bottom line as much as mark-up. There is more misinformation and misunderstanding about this basic mathematical formula causing grief even for the most sophisticated contractor. This article will clarify mark-up with construction and help the contractor better understand how to apply the formula.
To grasp this concept, the reader must first understand some history associated with mark-up. Next, a modern approach is adopted which requires an understanding of hard and soft costs. Once the two types of construction costs are incorporated, the contractor will learn how to read and interpret a basic profit and loss statement. With this knowledge they then can calculate the mark-up needed to achieve financial success. It all begins with a little historical perspective.
History of Mark-Up in the Construction Industry
For years, the core formula for mark-up in the construction industry was a simple 10 and 10. This meant that the contractor would mark-up all costs by 10% to cover overhead and then this value was in turn marked up another 10% for the contractor’s profit. This formula was quite common through the 1970’s. It was crude, but it worked well as costs were easy to identify. However, since then, costs have become more convoluted. In the 60’s, labor cost was easy to calculate. You simply multiplied the employee’s wages by a factor of about 1.1 and you had the average cost per hour for labor. Why 1.1? Well, in those days, workers in the construction industry did not earn benefits or had access to a retirement plan. Furthermore, you only got paid when you worked. No paid time off existed for any reason. The factor of 1.1 was to cover employer taxes. Thus costs were easy and simple to calculate.
That has changed significantly since then. Now, state employee wage laws, mandatory federal compliance and insurance has changed all this. The industry changed to incorporate labor benefits as ‘Soft Costs’.
Hard and Soft Costs
Hard costs of construction are easy and straightforward. These are the costs that it takes to build the project. A simple way to understand this is that hard costs are left behind when it is all over. They are tangible in nature. Examples include materials, the labor to construct the project, subcontractors and some intangible costs (permits, environmental fence, debris removal, port-a-john, equipment utility, etc.). Think of hard as those costs that you clearly must have to complete the project. Or another way to put this, these are costs you know must be paid to construct the project, i.e. they are directly assignable.
It is the soft costs of construction that many contractors fail to understand or grasp. Soft costs are generally intangible in nature but are necessary with construction. Here is a short list:
- Management (project managers, owners, engineers, estimators)
- Transportation – trucks, vehicles, trailers, shipping etc.
- Insurance – workers’ compensation, general liability, property, bonds and auto
- Employee Benefits
Notice the distinct difference between hard and soft costs? For most contractors, transportation and insurance are the most expensive soft costs after management payroll. Over the last 25 years, the author has read hundreds of financial reports for a multitude of contractors. The overall average of transportation and insurance as a percentage of contracted values equals 7% combined. In general, all soft costs run between 17 and 23% depending on the type of contractor and the magnitude of management payroll. Interestingly, really large contractors that perform government contract work such as construction of schools, hospitals, roads, bridges, etc.; they accumulate these soft costs and are allowed to allocate them to the project as a hard cost. Thus, their soft costs decrease dramatically due to this pooling and allocation as a hard cost.
Notice a discrepancy between the old days of 10 and 10 and the fact that modern day soft costs are in the 20% range? The out-dated 10 and 10 formula will not even cover modern day soft costs. To make this a tad more complicated, overhead is still another layer of cost. What is overhead? Think of overhead as the front office costs, the administration and marketing part of the company’s operation. In general, most small contractors (those doing less than $20 million per year) average about 7% of contract value for overhead costs.
Why is it so important to understand soft and overhead costs? Both costs play a critical role in the format of a standard profit and loss statement for a contractor.
Profit and Loss Statement Format for Construction
The P&L for a contractor is formatted differently than the traditional presentation format for most other industries. A simple presentation format for construction looks like this:
Profit and Loss Statement (Summary Format)
Period Ending April 30, 2020
Contracted Income $Z,ZZZ,ZZZ
Costs of Construction:
Hard Costs $Z,ZZZ,ZZZ
Soft Costs ZZZ,ZZZ
Total Costs of Construction Z,ZZZ,ZZZ
Gross Profit (Margin) ZZZ,ZZZ
Net Profit $ZZ,ZZZ
Why is it so important to understand all of this in order to understand mark-up with construction?
The key to understanding mark-up is understanding the margin value first. Mark-up and margin are not the same! The best way to understand this is to illustrate assuming some reasonable values for a contractor. Here are the assumptions:
- Desired profit of 8.2% of contracted income;
- Overhead is 7% of contracted income;
- Soft costs are 19% of contracted income.
Assuming the contractor closed $9,000,000 in contract work in the year; what would the profit and loss statement look like given the assumptions?
Profit and Loss Statement (Summary Format)
Year Ending ZZ/ZZ/ZZZZ
Contracted Income $9,000,000
Costs of Construction:
Hard Costs 5,922,000
Soft Costs 1,710,000 *19% of Income
Total Costs of Construction 7,632,000
Gross Margin 1,368,000 *Margin as a % of Sales = 15.20%
Overhead 630,000 *7% of Income
Net Profit $738,000 *8.2% of Income
The known profit, overhead and soft costs allow the formula to determine actual hard costs at $5.9M. Notice the margin is 15.2% which covers 7% overhead and delivers an 8.2% net profit. This is important for the reader, mark-up and margin are different; margin is the gross profit after deducting costs from revenue; mark-up is the percentage on costs. Mark-up is not a percentage of revenue (sales).
Now the mark-up can be calculated.
Mark-Up with Construction
Mark-Up is the multiplier on a value to determine the final price. From above, the final price is $9,000,000. The question is: ‘What value is used as the basis for mark-up?’.
The answer is ‘HARD COSTS’. Why hard costs and not total costs?
Remember from the historical perspective above, costs of construction were relatively easy to determine in the past. Modern day costs associated with soft costs convolute the formula. Thus, the ready known is hard costs. Think about this for a moment. When preparing the estimate, what costs are most commonly used? Hard costs are used. Soft costs are relatively unknown and not directly assignable to the respective project being estimated. There is no way an estimator can know how much fuel, repairs and maintenance for the trucks can be allocated to this project. Those and other soft costs are simply unknown and can’t possibly be estimated to a high degree of certainty related to the project being estimated. However, hard costs are easy to determine and aggregate into a final value. Thus, mark-up with construction is done on HARD COSTS only with small contractors (those doing less than $20M/Yr in contracted income).
Therefore, we have two knowns for the mark-up formula. Thus, what is the mark-up percentage (multiplier) for this contractor? Let’s start with the core formula:
$9,000,000 = (Mark-Up% represented by Y times Hard Costs) + Hard Costs
$9,000,000 =( Y*$5,922,000) + $5,922,000
($9,000,000 – 5,922,000) = Y*$5,922,000
$3,078,000 = Y*$5,922,000
$3,078,000 = Y
51.97% = Y
Therefore, mark-up on hard costs = 51.97% or basically 52%.
Let’s reverse engineer the result. Hard costs of $5,922,000 times 52% = $3,079,440 of mark-up. Adding $3,079,440 to $5,922,00 = $9,001,440. The difference is due to the rounding up of .03%.
In general, mark-up on hard costs for new home construction will average between 42 and 55% depending on the contractor’s volume of soft costs. Remodeler’s have a much higher percentage of soft costs driving their respective mark-ups above 70%; often reaching 90%. Again, the key are those soft costs. If you want to calculate your mark-up, use the above format. You simply need to know what your desired percentage of net profit is, overhead, the cumulative soft costs and the anticipated total contract sales for the year. Then mark-up can be determined using the formula above. Your mark-up percentage will come close to the averages indicated here. For those of you involved in the trades, expect higher mark-ups; do not be shocked if the mark-up exceeds 120%. ACT ON KNOWLEDGE.