As a contractor, you have to wear quite a few hats. Not only are you a tradesperson, but you’re also a business owner. And as a construction business owner, you need to understand how typical contractor overhead and profit work.
Knowing how construction overhead and profit work is critical to developing and winning bids. With unreasonable expectations, you’ll price yourself out of the competition. With too low a bid, no one will take you seriously, and if they do, you’ll be running in the red before long. Understanding the difference between overhead and profit is the first step. While the two terms often pal around together, they’re entirely different.
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Typical overhead and profit for contractors
Overhead is the cost of running a business. In construction, overhead typically includes the cost of subcontractors, machinery, equipment, insurances, office staff, office supplies, vehicles, and other costs. These can split up into two sections: direct and indirect. Direct overhead costs are allocable to a specific job (such as an equipment rental), while indirect costs are not (such as the cost of the office holiday party).
Profit is the amount of money left after subtracting the job cost and overhead amounts from the contract price. So, for a $20,000 project that costs $15,000 in materials and $2,500 in overhead, the remaining $2,500 is the profit.
In 2019, the NAHB performed a national survey consisting of data from over 6,500 home builders. That data showed that the typical overhead on construction projects in 2019 was roughly 11%, and the typical profit was roughly 9%. Those percentages are very close to the “10 and 10” rule that most construction businesses consider their target.
Levelset’s 2021 Construction Cash Flow and Payment Report shines a little bit more light on typical contractor overhead and profit. It shows that 61 percent of general contractors made 10% or more in profit on their projects. The survey also showed that 61% of residential construction companies made more than 10%, while numbers representing commercial and government contractors were 40% and 42%, respectively.
Contractor markup vs. profit margin
Contractor markup and profit margin are not the same. The profit margin comes out of the markup, but the markup contains much more than just cash in the bank.
When a contractor marks up the job cost, they need to mark it up enough to account for overhead and profit, and it’s the overhead part that can get tricky. This portion of the markup needs to account for the direct costs associated with the project, and the indirect costs of running a business.
Direct costs in overhead might include bonds associated with the project, subcontractors on the job, equipment rental, and permits.
Indirect costs might include office costs (mortgage/rent, utilities, supplies, personnel salaries, cell phones, etc.), vehicle costs, employee perks (parties, bonuses, event tickets, etc.), marketing, insurances, and your salary.
All of those things need to come out of the overhead portion of the markup. The money left over after squaring those items away is the profit. So, what’s the takeaway here? You have to know your overhead costs as well as your desired profit margin to mark up correctly.
How to calculate overhead and profit correctly
The 10 and 10 rule refers to the goal of keeping overhead around 10% of the project while striving for 10% profit on the job.
But, contrary to what many in the industry believe, simply marking the job cost up by 20% doesn’t do the trick. In fact, if that’s your bidding method, you’re either shorting your business or not paying all of your bills.
For example, let’s look at a small job with round numbers: A finish carpentry contractor is bidding on a job to replace doors in an office building. The job cost is $10,000.
If the contractor marks the cost of the project up by 20%, the bid will be $12,000. If the contractor subtracts 10% ($1,200) from the bid price, there will be $10,800 leftover. Since we already know that the job cost is $10,000, that leaves just $800 for profit, rather than the goal of $1,200. That’s quite a mistake.
To achieve the goal of 10% profit and 10% overhead, the contractor must actually mark the job cost up by 25%. With the job cost of $10,000, this increases the job price to $12,500. Subtracting 10% ($1,250) leaves a remainder of $11,250. Now, subtracting the original job cost of $10,000, the contractor is left with $1,250 in profit — exactly 10% of the job cost.
Example of project profit and overhead
Let’s take another look at these overhead and profit percentages from a different perspective.
ABC Concrete is bidding on a job. They believe the cost of the job will be $100,000, and they know their overhead needs to account for 12% of the contract price. However, to bid competitively, they stick with the 10% profit margin.
If ABC marks the project up 22% (the sum of the overhead and profit percentages), they’ll fall short and cut their profit. Why? Take a look, and remember that 12% of $122,000 is $14,640 and 10% of $122,000 is $12,200:
- $100,000 + 22% = $122,000
- $122,000 – 12% = $107,360
- $107,360 – 10% = $95,160 (-$4,840 from the job cost)
Since we know that the job will cost $100,000, this equation reduces the contractor’s profit by $2,800.
Instead, the contractor will need to mark the cost up by roughly 28.2%. Here’s how those numbers work out:
- $100,000 + 28.2% = $128,200
- $128,200 x 12% = $15,384
- $128,200 x 10% = $12,820
- $128,200 – $15,384 = $112,816
- $112,816 – $12,820 = $99,996
This equation actually brings the contractor’s profit closer just slightly under 10%, but it highlights the importance of crunching your numbers.
6 tips to boost profit and reduce overhead
Your company’s vision should be one of growth. Aside from taking on bigger projects or a higher volume, growth comes from increasing your profits. The following are some tips for boosting your profit margin and reducing your overhead, allowing you to improve your profitability.
1. Increase your profit margin
Obviously, one way to make more money is to identify your profit margin and increase it. If your business has been making 8 or 9% profit on its jobs, consider increasing your prospective profit margin by one or two percent.
However, it’s not a good idea to jack your prices up on your existing customers overnight. Give them notice that you’re bringing your company’s profit margin up to snuff with the rest of the industry and slowly increase it over the next six months or so. For new customers, the new rate is the new rate.
2. Find out what you’re missing
If your desired profit margin has always been 10% — or any number for that matter — but you consistently fall below that margin, there must be a reason.
First, have a good look at your bids and job costs. Do they jive, or have your estimates been totally off the mark? Then, take a look at how you’re building your markup.
How much of it is overhead? What does that overhead consist of? Are you including all of your indirect costs, or have you let a few slip by undetected? Your missing percentage probably lies somewhere in your bidding process.
3. Automate your business
If you want to cut overhead, consider streamlining and automating the areas of your business that make sense. By relying on construction management software, you’ll be able to create more efficient processes for your accounts payable and receivable, as well as reduce the strain of office staff.
Also, by moving to a construction-specific software program, you’ll have access to drawing storage, compliance management, automated workflows, and other time-saving benefits to reduce the hours spent by office staff doing menial tasks. Your personnel can then focus on more important tasks, leaving the repetitive data entry to the software and more money in the company’s account.
4. Establish an accounts receivable policy
Before you can improve your profit margin, you need to protect the one you have. Establishing an accounts receivable policy will lay the groundwork for recovering as much of the profit as possible.
Here are some of the most important questions to answer:
- Will you send preliminary notices on all of your jobs, or just the ones you expect might have issues? (Hint: All of them!)
- Will you offer early payment discounts? If so, how much and by when?
- When will you send a payment reminder? What about a notice of intent to lien?
- Will you use a collection agency?
- Are your policies protecting your right to file a mechanics lien in your state?
5. Pay attention to your accounts payable
Be sure to focus some time on improving your accounts payable, as well. If you aren’t paying your materials suppliers or subcontractors on time, their late fees might be eating into your profit.
Moving to automated software will be a huge boost. Subs and suppliers will be able to submit pay apps online, allowing you to get them turned around faster to avoid payment delays and the subsequent issues they cause.
Also, contact your subs and suppliers and ask if there is a discount for paying your bill early. If they’re bidding correctly, they’re accounting for interest in their bids. If you pay them early, they should be able to save on interest and transfer the savings to you, as well. This lessens your overhead and grows your profit margin by default.
6. Consider interest
The interest you pay to credit card companies and materials suppliers could be affecting your profit margin. If you aren’t accounting for these rates, or the job takes much longer than expected, the money you’re paying to borrow cash adds up in a hurry.
There are a few things you can do here. One, shop for a credit card with an 0% introductory rate. Next, you can call your credit card company and request they lower the interest rate. Finally, find a materials financing partner to help you purchase materials with a lower interest rate than the rates offered by credit card companies.
Get materials now, keep your cash.
Enjoy 120-day payback terms with any material supplier.
Contractor overhead and profit don’t happen by accident
When you’re putting together your next bids, realize that the money that goes to overhead and the money left over shouldn’t be an accident. Get a handle on how you calculate overhead as well as how much profit your business plans to make before bidding.
Also, do what you can to protect your profit margin and reduce your overhead to keep your company profitable and ahead of your competition.