Minimum Bottom Line Profit Should Be > 7%!
After Income Taxes Are Paid!
When I was 18, I had a job as a framer’s helper. Mostly I lugged lumber to the house under construction and did a lot of nailing with my 22 ounce hammer. In those days, there were no nail guns. The sales price for that simple ‘A’ frame house was $34,000. In those days, that was expensive. I remember well wondering how much the contractor made building that house. I looked at costs as simply as land, lumber and labor. For sure, it was simpler in those days, the contractor had less costs than modern day construction. One good example is the port-a-john, in those days I sought out the woods, today temporary facilities are required by code everywhere. Since doing accounting work for multiple different contractors, I’ve learned that every home has a lot of other costs that are not directly related to the project itself. With all these additional costs, how much does a contractor mark up the costs to get a profit that is fair and keeps him in business.
To help you understand this, this article will explain the fundamentals of markup and its application to construction. Most of you will be shocked at the mistakes you are making. Once you understand the fundamentals, successive articles will go into more depth on some of the major cost groups to help you more fully understand markup and how to end up with a profit that is fair and keeps you building more homes.
To understand the fundamentals of markup in construction, the reader must first understand the business principle of markup. Next, I will distinguish hard costs and soft costs as they are used with construction. Finally, I will tie it altogether for the contractor and if I do this right, you should have an ‘AH HAH!’ moment at the end.
What is Markup?
Markup has a very simple definition, it is the amount added onto costs to create a sales price. Notice something really important with that definition, it does not define profit. It merely defines how much to charge over costs so you can make a profit.
MARKUP – AMOUNT ADDED ONTO COSTS TO DETERMINE SALES PRICE.
This is the primary basis of mistakes made by just about all unsophisticated businessmen, they believe the markup percentage equals the profit percentage. The markup in dollars equals the profit in dollars, BUT NOT as a percentage. Most markups are done as a percentage. Allow me to illustrate:
Joe built a home costing a total of $187,00. He marks up these costs $53,000 and sells the house for $240,000. Joe figures his profit as follows:
Sales Price $240,000
Costs of Construction (187,000)
Joe’s markup is 28.34% on costs ($53,000/$187,000). When Joe multiplies $187,000 by 28.34% he gets $53,000 of profit. Joe thinks his profit is 28.34%; is he right?
When profit is calculated, it is calculated as a percentage of the sales price, not as a percentage of the costs. Since the sales price is greater than cost, the profit percentage (it is referred to as margin percentage in accounting) will be lower. Let’s do the math:
Sales Price $240,000 100%
Costs of Construction (187,000) 77.92%
Profit $53,000 22.08%
Wait a minute, we marked up the costs by 28.34% and yet ended up with a 22.08% profit margin.
PROFIT MARGIN DOES NOT EQUAL MARKUP.
Basically, if a business owner wants a 22.08% profit margin, the company must mark up their goods 28.34%. Here is basic profit margin/markup table.
Profit % Desired Markup on Costs Required
What is really interesting is that the profit percentage column rises at a linear rate, 5% increments. Yet the markup column is not linear, it actually increases at an increasing rate. If you asked a fellow businessman what the markup should be to get a 40% profit margin, he will most likely respond with something less than 66.67%. This is where you lose money, this is why it is important to understand the relationship between the two columns. One is linear, the other is not. If a 20% profit margin is desired, markup is 25%; double the profit margin to 40%, the markup more than doubles, it actually goes up by a factor of 2.66. THERE IS NO LINEAR RELATIONSHIP BETWEEN MARKUP AND MARGIN.
Now that the basic concept of markup has been explained, let’s relate this to costs.
Hard and Soft Costs
There is more to the construction of real estate improvements than just the lumber and labor. As stated in the opening paragraph, I lugged the lumber to the house. The lumber is a hard cost, you can actually touch it. It takes labor to cut it properly and nail it so it is structurally sound. Labor is also another hard cost. This is true for all the phases of construction, from digging the footer and pouring concrete to the final paint brush stroke to finish the house. All of these costs are referred to as hard costs. The problem is that there are other costs that can’t be seen once the house is finished, but these other costs were instrumental in its construction. These are referred to as soft costs.
The following is a list of the more common soft costs:
- Labor Burden
- Project Management
- Project Capitalization (interest on project note, closing costs on the note)
- Closing Costs (often twice, once to buy the lot and then to close when the project is sold)
- Governmental Compliance
- Professional Fees (Legal and Brokerage)
The number one soft cost is the labor burden related to the actual direct cost of labor. When that project is under construction, many accountants post the labor costs straight to the project. Most of this labor cost is the actual wage paid to the laborer. But a company pays more than just the wage to the employee. There are other costs for labor, this is called the labor burden as it adds onto the actual rate per hour the employee is paid. Here is a short list of the most common labor burden items:
- Matching Payroll Taxes
- Worker’s Compensation Insurance
- Vacation/Sick Time
- Retirement Benefits
- Medical Care
- Eye/Dental/Cancer Insurance
There are even indirect costs of labor such as training, safety equipment and tooling. The direct burden costs typically range from 18% to 32% of the employee’s hourly rate. Of course the most expensive item is providing worker’s compensation insurance which ranges from 6% to 13% of direct labor. The indirect costs of training, safety and tooling add an additional 2% to the direct burden costs.
Most of these soft costs are not posted directly to a project with cost accounting. When estimators generate an estimate for a project, many of these soft costs are not included. This is important, this means that markup is most commonly done with only hard costs and not on soft costs or all costs of construction.
Some estimators are told to add a certain percentage onto the direct labor cost to cover the labor burden costs, but you rarely see an estimate for such things as transportation, communications and project capitalization. But all these costs are now necessary to complete a project. As stated in the opening statement, in those days the contractor didn’t have to worry about putting a johnny on the job site, as far as he was concerned, you were on your own. Today, the contractor has multiple governmental compliance requirements: environmental fencing, security, providing utilities, inspections, documentation and more. Soft costs have become increasingly a greater share of the overall costs of construction. On average, soft costs run around 25% of hard costs. Think about this for just a moment, soft costs are 25% of hard costs, therefore a minimum markup has to be 33.33% (see the above table) just to cover these soft costs to construct any project.
Naturally, the more material intensive the project, the soft costs decrease as a percentage of hard costs. This basic principle is a reflection of reduced soft costs as labor becomes less of a hard cost as a percentage of the project. Think of a concrete and steel structure, soft costs here are around 18% whereas with multiple phases of construction and all sorts of materials and skilled laborers such as residential construction, soft costs increase to around 30% of hard costs.
This leads to the next important fundamental rule related to construction, the greater the diversity of hard costs, the higher the markup must be to address soft costs.
If your estimating program includes soft costs and can capture as many of the soft costs as possible, then the markup formula is on a much larger number and therefore the markup percentage is lower. When estimating and using only hard costs, then markup on hard costs must be greater to cover the soft costs of construction. A typical contractor should think like this:
Hard Costs $ZZZ,ZZZ
Soft Costs ZZZ,ZZZ
Total Costs $Z,ZZZ,ZZZ
Markup on All Costs ZZZ,ZZZ
Total Bid $Z,ZZZ,ZZZ
Hard Costs $ZZZ,ZZZ
Total Bid $Z,ZZZ,ZZZ
Often the second method tends to generate lower profit margins and less net profit at the end of the accounting year. The contractor is failing to take into consideration all the soft costs that every project requires.
Fundamental Rules of Markup for Contractors
The above can be summed up into several rules for contractors to use:
- Markup is not profit margin; it must be significantly greater than the desired profit margin.
- Markup should be based on both hard and soft costs combined. If excluding soft costs, the markup can not be less than 33.33% on hard costs.
- The more material intensive the project, the lower the markup can be; whereas diversity of materials, skilled labor and building methods demand higher markups.
I can’t tell you how often I see an old fashioned rule of 10 and 10 on hard costs. Basically the contractor is saying I want a 10% gross profit margin to cover my soft costs (commonly stated as overhead) and then a 10% profit. The first mistake they make is that they do this as markup on hard costs. Right from the start, the first 10% desired margin to cover overhead is an error because to get 10% margin you must mark up the hard costs 11.11% to get this necessary margin to cover overhead. Next is the markup necessary to get the 10% profit desired. Now the costs are 111.11%; thus the markup needed to get a 10% profit on this 111.11% cost structure means the next level of markup has to be 12.36% of the original hard costs. Therefore to get a 10 and 10; the total markup must be 23.46%. To prove this, look at this schedule:
Hard Costs $187,000 (90% of Total Costs)
Soft Costs as 10% of Total Costs 20,777 (10% of Total Costs)
Total Costs 207,777 (100% of Total Costs, But 90% of Sales Price)
Markup So Profit is 10% of Total Sales Price 23,087
Sales Price $230,864
Total markup in dollars is the difference between the sales price and hard costs which equals $43,864. To get this, the total markup percentage on hard costs must be $43,864/$187,000 or 23.46%.
The next article in this series will explain all the various soft costs that exist with construction and how to address the markup related to these soft costs. ACT ON KNOWLEDGE.