The textbook answer defines cost drivers as those factors that determine the overall cost of operations. As an example, in manufacturing the cost drivers may be processing time or number of steps to produce the product. With service, the cost drivers could be the actual ratio of billable to non-billable time.
Real profit refers to the total value a small business generates for its owner(s). For an owner of any business, given the number of hours, stress, and personal commitment an owner has to make, anything less than $100,000 a year in real profit or earnings is not worth the risk associated with the running a business.
‘Fixed costs’ is a business term used mostly in cost accounting. It has several meanings based on its usage. The most common definition associated with fixed costs is expenses that must be paid regardless of production or sales volume. The best example is rent for a company. It doesn’t matter whether you produce or sell one widget or several thousand, the rent must still be paid.
So why is it important to understand fixed costs? How is it used in cost accounting and in financial reporting? Finally, what are examples of fixed costs?
Many people turn their hobbies into a business operation. Not so much to make a living or make big profits, but more to help offset the costs of the hobby. Whenever you go to one of those community fairs, the vendors at the respective booths are mostly folks selling a product that is direct outcome of their hobby. The bands that play on stage, they make some money, but never enough to offset the cost of instruments, gear and transportation. But they enjoy entertaining folks and they hope someday they’ll get discovered.
A third factor in determining a fair profit percentage is risk. Risk is divided into two types. The first is insurable and the second is uninsurable risks. Insurable risks are mitigated and have very little to no effect on the profit formula due to transferring the risk to a third party known as the insurance underwriter. Uninsurable risks are non-transferable and therefore the profit must be adjusted to compensate for this type of risk.
For any company, profit is based on the risk reward concept. With construction, what should be the profit (reward) given the risk? What is a reasonable expectation given the industry and the particular business? There is no single correct answer. The construction industry is divided into several significant branches. This article is focused on the residential contractor.
From the new home builder to the re-modeler, a reasonable profit given the risk should be no less than 9% AND this is net after a reasonable salary to the owner for his management role. This is the take home or actual bottom line profit; the amount after taxes. How do you derive such a figure? How do you determine the markup on the construction project to end up with this profit?