Contractor profit in the construction field is a tough proposition. Between the painfully slow payment times and razor-thin profit margins, it can be downright difficult to get ahead, let alone stay there.
Determining and planning for your profit margins ahead of time is the only way to ensure you’re making money on every job. If you’re waiting until the end of a project to subtract your receipts from your checks, you’re doing it wrong.
But there’s good news: You can correct the course and learn to plan for your profits. In fact, it’s not even all that difficult. It just takes a little background information, a bit of awareness, and some realistic estimates, and you could take your company from floundering to flourishing without ever leaving your desk.
Let’s dig in.
Profit and cash flow: What’s the difference?
The first thing you need to understand before you can truly plan your profit margin is that profits and cash flow are not the same. Yes, you need them both, but they serve different purposes.
Profit, in simple terms, is the amount of money your company makes on a project. It’s the amount of money left over from a project after you account for all of your overhead, operating expenses, and other costs associated with the project and doing business. Profit doesn’t even include your salary — that needs to be part of the overhead.
Cash flow is a term describing the money coming in and going out each month. To put it simply, to be a sustainable outfit, a contractor needs to have more months of more cash coming in than going out each year.
A company can be profitable, if not flush with profit, on paper. But, if the company can’t collect on the cash owed to it, it won’t have a positive cash flow. Overhead like labor, rent, credit accounts, utilities, and other expenses continue to draw on the bank account each month.
That old saying, “As long as I owe you, you’ll never be broke,” simply does not apply. You can definitely be broke with profitable contracts and failing cash flow.
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Cost markup is not your profit
There’s a rule in the construction industry known as the “10 and 10” rule. It refers to a successful bid including 10% of the total for overhead and 10% of the total for profit.
We’re pretty good at math, right? Ten plus ten is twenty. Marking up project costs by 20% should do the trick. Article over.
But…hang on a second. Percentages are a son of a gun.
Your math’s not wrong — but marking up your costs by 20% doesn’t lead to a 10% profit margin. The devil’s in the details, or in this case, the equation. Let’s look at why.
Marking up twenty percent doesn’t work
Let’s say you’re a finish carpentry sub. You won a contract to hang doors and trim out a new build. The project cost is $10,000.
If you mark the project up by 20%, you will submit a bid for $12,000. That should leave you with 10% for overhead, 10% for profit, and $10,000 for the job, right?
Well, not exactly. Overhead is 10%, and it’s a hard number that you can’t fudge. What’s 10% of $12,000? $1,200. Uh oh. Are you seeing the problem yet? Hang in there.
Now subtract that $1,200 from your original bid of $12,000. That’s $10,800.
You already know that your cost is $10,000, so that leaves you with just $800 in profit left over. That’s a bit short of your original goal of $1,000 profit. In fact, in this scenario, you inadvertently planned for a 6.67% profit.
How to mark up to hit your goal
You goofed: You’re still profitable, but you’re not hitting the 10 and 10 rule. To make that happen on a $10,000 job, you need to mark up your costs by 25%. Here’s why:
Adding $10,000 for job cost plus 25% comes out to $12,500. Subtracting 10% ($1,250) of that for those hard, unwavering, undeniable overhead costs will leave you with $11,250.
Now, here comes the magic. Subtract the job cost from this number, and you’re left with $1,250; 10% of your updated bid.
Congratulations, you hit the 10 and 10 goal.
Many homebuilders fall short
While the 10 and 10 rule is a great goal to aim for, the industry is clearly missing a step.
The NAHB 2019 survey of residential homebuilders details the numbers:
“On average in the 2019 NAHB survey, 61.1 percent of the final house price was attributable to construction costs, 18.5 percent to the cost of the finished lot, 4.9 percent to overhead and general expenses, 3.7 percent to sales commissions, 1.7 percent to financing costs, 1.0 percent to marketing costs, leaving 9.1 percent for profit (prior to taxes).”
Not only does 9.1% profit fall short of the 10% goal, but the 11.3% for overhead (the sum of all other costs) exceeds the 10% overhead goal.
Things are just slightly out of balance, but those discrepancies can add up to significant sums of cash over the course of a building year.
9 Steps to contractor profit
Following these steps on every project will help keep your business profitable and ensure you have a favorable cash flow scenario.
1. Calculate overhead
To be effective at planning, you need a concrete understanding of what your overhead looks like. There are aspects of overhead that may fluctuate a bit, like utilities, but they’re often fairly easy to calculate. Insurance premiums, rent, your salary, and sales commissions should stay relatively consistent. Get a solid handle on what the cost of doing business looks like for your company.
2. Determine job costs
Unlike overhead, job costs can vary significantly from project to project. While time and experience will help smooth the learning curve, you’ll have to evaluate this closely on every project.
3. Establish reliable relationships
It’s hard to fully grasp how much a project will cost if you’re working with new subs and suppliers on every contract. Start building smart, equitable relationships with other businesses that you can trust to deliver. When they give you a price, you’ll know they’re good for it.
4. Set your price
Once you know how much to factor in for overhead and how much the project will cost, you can use a set percentage that works for your company to set your price. The percentage may change slightly between projects, but you’ll have a good idea of how much markup to build into the price.
5. Choose customers wisely
If you aren’t prequalifying customers, you’re doing yourself a disservice.
Whether you’re contracting directly with a homeowner or working for a GC, do a little homework. It’s okay to want some background on their credit history and payment practices before diving into the deep end with them on a project.
6. Protect your payments
Remember the negative cash flow example from earlier? Don’t let that happen to you. Filing a mechanics lien is the most powerful tool contractors have to collect on money owed to them for work they completed. Learn the laws around mechanics liens in your state (or any state you work in), send preliminary notices, and keep track of lien deadlines to ensure your payments continue to roll in.
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7. Communicate regularly
Yes, preliminary notices often protect your payments, but they can also serve as a friendly introduction with the GC or project owner. This notice lets them know you’re working on their project.
Be sure to follow up on payment applications with reminders and eventually demand letters if payment starts to slow down.
8. Keep track of your financials
If you want to be able to pivot and make smart decisions on the fly, you need to have a grip on your financials. One of the best ways to keep your finger on the pulse of your financial health is by using construction-specific accounting software.
Generating financial and accounting reports automatically and instantly will allow you to make better decisions. When it comes to the bottom line, a job profitability report can show you exactly where you’re winning or losing.
9. Learn and adapt
Check your reports regularly and change your policies when you need to. When it comes to your credit policies, be sure to take past experiences into account and adjust your terms accordingly. Finally, be sure to train your employees regularly and keep your sales staff updated on any important pricing changes you adopt.