Markup on Materials – Setting the Proper Rate

 

Minimum Bottom Line Profit Should Average 9.4%!
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There is no preset national standard for markup on materials. The Internal Revenue Service’s Construction Industry Audit Technique Guide (May 2009) states that from the Means Contractor’s Pricing Guide include a standard 10% markup on material for profit. However, profit is only one portion of total markup; therefore, markup on materials starts at a minimum 10%. In some cases markup on materials can exceed 100%. This article provides guidance to the contractor, estimator or project manager with setting the markup rates on materials.

Setting the proper rate requires the management team to understand that materials exist in a spectrum of condition, from simple raw materials status to highly complex and intricate status such as technology. The materials position on this spectrum greatly affects the markup formula. In addition to understanding the materials condition; other factors affect markup such as availability, delivery, condition, security and compliance. All of these issues impact the markup formula with materials. To assist the reader in understanding markup on materials, the first section below is a summary understanding of what and why markup with construction is performed.

 

Markup With Construction

Markup in the construction is different for each contractor. There is a plethora of contributing factors adding costs to conduct business. In general, there are three types of costs for a contractor. The first and the most expensive is direct costs of construction. These are the materials, labor, subcontracting, equipment and other direct costs to build the structure and complete the project. Markup with construction is calculated on direct costs of construction to cover the other two cost groups and provide a profit. The other three are as follows along with some examples:

  • Indirect – management payroll, insurance, transportation, tooling, communications, and compliance
  • Overheadoffice operations, upper management and front office payroll, accounting, professional, taxes, capital costs and marketing

The standard formula for markup is as follows:

Direct Costs of the Project PLUS Direct Costs * Markup Rate to Cover Indirect and Overhead = Cumulative Value;
Cumulative Value * Markup Rate of Desired Profit;
= Final Proposal Price

The standard formula is a two step process, however it can be condensed into a one step formula by combing the multiplicative factors of markup for indirect/overhead and the desired profit.

For most contractors, the minimum markup is 27% with a reasonable markup in the 40% range. Trades and remodelers have higher indirect and overhead cost structures related to sales; thus their markups are in the 70% to as much as 100% range. 

Materials is just one of the many direct costs of construction. Thus, its markup factor can exceed 100% depending on the circumstances. The key is to understand the underlying conditions associated with the respective materials.

Materials Status Has The Most Significant Bearing on Markup

Material status refers to its position along the spectrum of condition. Materials can be in the form of raw status such as fill, sand or stone; or it can assume the next position along the spectrum and be processed. Thus, stone can be processed into crushed stone and therefore moves towards a higher state of condition. The following is the materials spectrum of condition, from lowest to the most sophisticated, and some examples associated with that condition:

  • Raw – no modification has been performed; in most cases it is mined materials such as fill, sand and stone.
  • Processed – raw materials are slightly modified into a different state. For example, lumber is cut, milled and dried before it is sold.
  • Composite – when one or two materials are combined it is referred to as composite; examples include wallboard, plywood, paint, asphalt, concrete etc.
  • Artisan – raw material is modified via human labor in order to fabricate unique or limited versions; examples include tile, cabinets, stone, fine woodworking sections, countertops etc.
  • Manufactured – common products include piping, wire, fixtures, insulation and windows.
  • Fabricated – custom made materials; typically composites combined into a system or single unit; examples include ductwork, beams, culverts, gutters, downspouts and drainage.
  • Engineered – some materials require certification in order to comply with legal standards such as water heaters, compressors, elevators, pulleys, roof trusses etc.
  • Technology – computers, switch boxes, inverters, motors, pumps and wholes systems require technological programing, testing and monitoring prior to delivery as materials for a project.

As the materials move from the lowest to the more sophisticated status, outside labor and businesses add value taking the particular material to the next level. For example, pipes are made from raw materials but have some engineered work done prior to ensure integrity and quality manufacturing the pipe. The same goes for wire, it is a composite of metal, paper, synthetic membrane and wrapped on the outside by a polyurethane coating to protect it from rubbing and cuts. A manufacturer took the raws materials and developed a process to produce wire. 

Each step up in sophistication means that another business added value and therefore had to make profit in order to cover their respective indirect, overhead and desired profit. Thus, as the materials used on a  job are more sophisticated the less working room for markup exists with the contractor. For example, a contractor can not markup a computer 100%; the client will simply purchase the materials their self. Whereas with less sophisticated materials, there is more room to work with markup percentages. It is not unreasonable to markup processed materials 40% to 60% in a proposal to a client.

In general, the more sophisticated materials have low markups (20% to 25%) and raw materials are at the other end of markup percentages; in some cases more than 100%.

There are still other factors that affect markup with materials; but the material’s status has the greatest bearing on the markup with materials in construction.

Other Factors Affecting Materials Markup in Construction

There is more to the materials cost than the actual core amount paid for the material. The most common factor affecting the total price of materials is delivery fees. Delivery costs range from free to custom delivery systems including the use of cranes or even heavy lift helicopters to place the material in the right spot. As the cost of delivery increases or its coordination becomes complex, the contractor should increase the markup to cover the additional indirect costs. Common examples include delivery to remote sites, material testing (slump tests for concrete), and bill of lading documentation. The more intricate or convoluted the delivery process, the greater the markup on the materials is needed to cover this addition risk exposure.

Another factor affecting materials markup is availability. Some materials are only available during certain times of the year or have long lead times to acquire them. Certain high end wood (teak, mahogany, ebony, zebrawood) materials have long lead times to receive the material. Often, custom contractors have to place options on the materials adding additional costs and associated risks. Thus, lack of availability allows the contractor to significantly increase the markup for rare materials.

A third force that can impact markup is the condition of the material. As materials tend towards the lower end of the spectrum of condition, materials receive grades of quality and this in turn has some bearing on markup. The higher the grade of material, the lower the markup. For example, grade 3 lumber is commonly used in the utility industry and for temporary structures such as forms for pouring concrete. It has a much lower cost to a contractor and tends towards a lower status on the materials spectrum, therefore more room to markup the cost to cover indirect and overhead costs. 

Other lesser factors affecting markup include security for the materials. In general, more sophisticated materials require greater security measures to prevent theft due to their higher value. In some cases, the contractor has to use a materials ownership process to transfer the materials from one point of holding to another in order to prevent theft. This is more common with rare or highly customized materials, think of uranium pellets for a nuclear reactor or a gearbox for a wind turbine. If security is required, the markup should increase to cover the additional indirect costs and associated overhead along with higher profit. 

In those unusual situations where the government is involved in signing off on the materials received, additional time and compliance documentation is necessary to receive the materials. Again, this additional step allows for greater markup on the respective materials.

Setting the Proper Rate for Markup on Materials

With most projects, materials compose 40 to 60% of the project’s hard costs. It is also the visual part of the end result. Thus, setting a universal across the board markup on materials is inappropriate. The contractor must adjust the markup depending on the materials’ status and other factors. It is important to think about the markup prior to determining the actual markup percentage.

For those situations where a master service agreement is signed with a client; be sure to evaluate what type of material the contractor will provide. Many master service agreements require materials towards the more sophisticated status along the spectrum. Therefore, the markup rate is lower. However, factor in availability, ease of access and delivery. In general, reasonable markups for this form of materials acquisition warrants a minimum 20% to 30% markup. In negotiations, remind the customer of the risks involved including time to research and find the appropriate part and acquire the part. Many clients only want to allow 10 to 15% as the markup. If the parties agree that 10% is a reasonable profit markup then the remainder (indirect costs and overhead markup) is easy to explain and settle on a rate. Additional markup has to cover documentation, insurance, management control along with communications with multiple parties. 5% for this additional indirect and overhead cost is simply unreasonable. For example, a master solar photovoltaic system service agreement with a large asset management company indicated that the contractor is allowed to charge an additional 32% for markup on materials purchased for the photovoltaic system contingent on the following terms and/or conditions:

  • Material’s receipt is included with the invoice from the contractor when created and sent to the asset management company.
  • Labor to order and verify delivery is excluded for the time element for the respective service work order.
  • Delivery charges are at pure cost to the asset management company.
  • Contractor agrees to include photos and serial number tracing to the asset management company.
  • Contractor provides property coverage until the component is firmly mounted to the hardware of the photovoltaic system.

At the other end of the materials spectrum are raw or processed materials. Markups below 30% are inadequate to cover the associated indirect, overhead and profit needed for the contractor. In general, materials at this end of the spectrum are lower in cost due to limited processing.

To illustrate this, assume the contractor is building a $1,000,000 retaining wall. Anticipated hard costs of construction are estimated at $585,000. Of this, materials comprise $381,000 and labor is estimated at 118,000 with the balance of hard costs assigned to equipment and other costs of construction. Since labor is tied mostly to manual labor, the markup on labor does not generate the needed contribution margin necessary to offset this project’s share of indirect, overhead and desired profit. Markup on materials has to be high in order to generate the needed dollars to cover allocated indirect and overhead costs along with a desired 14% profit before taxes. In this case, materials markup exceeds 60% on average. Here, the estimator tiered the materials based on position along the spectrum and took into consideration delivery issues, weather conditions, site access and timing (plants and sod) to create an overall average of 60%.

For those involved in site development, markup on raw materials should exceed 100% due to the process necessary to ensure proper placement, volume and grade. Since raw materials are generally inexpensive, markups of this magnitude do not adversely affect the overall pricing structure for the proposal made to the client.

Use a spreadsheet and group the respective materials along the materials spectrum. Have separate columns for the spectrum position to identify markup. Add other columns to indicate the other factors in order of significance which will be different depending on the contractor. In effect, the spreadsheet is a cumulative markup calculator depending on the nature of the respective material. The following is an example used by a home remodeling contractor.

XYZ REMODELER INC.
Materials Markup Workbook
Project ID #20200317
Materials Group     Examples                        Minimum Markup        Timing       Storage/Security   Weather     Documentation     Total Markup
Raw                           Fill/Sand/Gravel                   80%                               2%                    0%                       0%                       0%                    82%
Processed                  Lumber/Sod/Plants               60%                               5%                    2%                       3%                       2%                    72%
Composite                 Sheetrock/Paint/Trim           50%                               6%                    4%                       1%                        3%                    64%
Artisan                      Cabinets/Countertops           40%                               3%                     7%                      2%                        6%                    58%
Manufactured            Doors/Windows/Fixtures     30%                               5%                     7%                      1%                        4%                    47%
Fabricated                 Ductwork/Gutters                 30%                               2%                     0%                      0%                        0%                    32%
Engineered                A/C Unit, Appliances           25%                               0%                     0%                      0%                        4%                    28%

Notice how this schedule follows the suggested pattern described in the sections above. In this case, the workbook had separate worksheets for the materials takeoff and summed the entire value for that respective materials group. Then the worksheets summed up into the  summary worksheet on page one of the workbook and followed the above estimated requirements per materials group. 

In general, home remodelers overall average markup in construction tends toward a minimum 80% and often higher. Thus, for this particular remodeler, labor burden and the associated markup addressed the difference. However, this schedule was used for any change orders per the contract with the homeowner thus negating any negotiations over the respective final price for the change order.

Summary – Markup on Materials Setting the Proper Rate

There is no single universal markup percentage (rate) for all contractors. Each company must create their own schedule tied to the respective indirect and overhead costs along with the desired profit. Prioritize the more common materials purchased into groups depending on their position along the spectrum of materials status. The more the material item has outside forces processing or performing some service on the material prior to selling it to the end user (the contractor), the less additional markup tolerated by the contractor’s end client.

The key to the proper markup rate on materials in construction is evaluating the company’s necessary minimum markup to manage the respective materials. Develop a markup schedule and test the outcomes with smaller proposals and make any modifications as needed. Act on Knowledge.

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