You've issued a quote for a job, and got it. It's a good project and things are going well, you're excited to get it finished and secure the nice profit.
Then you realise something, just before this gut wrenching feeling hits you...
You realise your price was too low and there's barely any profit. You're basically working for free on this one.
All the satisfaction from securing the job instantly disappears.
You messed up, and now you're in a really bad situation. A situation that has no good solution. In other words...
Understanding markup, overhead, and profit
If you've ever been in a situation like this before, you know how much it hurts. But fear not: most general contractors will find themselves there at some point.
The trick is to learn from your mistakes, because if you keep making this mistake then your business will eventually run out of money and fail. Simple as that.
Understanding how to set a price based on a solid methodology rather than rough estimation and guesswork will go a long way towards helping you avoid similar situations.
I'm going to help you get a better understand of all this, so let's get to it.
Overhead, net profit, gross margin... what is all this crap?
Maybe you know what these terms mean, maybe you think you do, or maybe you have no idea. Whatever the case, here's a breakdown of these terms and how it can help you to improve your pricing to make more money.
There are two categories of costs for most general contractor businesses.
That is the price at which you will break even for the job. You won't make money, but you won't lose money either.
Now obviously the price needs to be higher than this, to include your profit.
Gross profit and gross margin, net profit and net margin
I'm going to define all these things and then I'll do some explanation, so stick with it.
Gross profit: The gross profit on a job is your income less direct costs associated with the job. The formula is:
Gross margin: The margin is expressed as a percentage, and it's a simple formula:
So your gross profit and gross margin apply directly to a given job. They are useful (as you will soon see), but ultimately your net profit is what matters.
Net profit: This is income from a job, less direct costs, less overhead. The formula:
As you can see, net profit shows the "real" gain from a job. If you do pricing based on just generated a gross profit, you can still make a loss on a job due to not accounting for overhead costs. A business which doesn't price appropriately to cover its overhead is sure to fail.
Net margin: Again this is expressed as a percentage. The formula:
The net margin basically tells you what return(profit) you're generating as a percentage of all costs associated with doing a job.
Understanding all of these terms and how the affect your pricing is crucial to the success of any general contractor business, from a handyman to a commercial developer.
Key point: The price of a job must include direct costs, overhead, and (most importantly) profit.
If you set a price that's too low, your profit is always the first of these 3 things that will suffer. And if you've ever found yourself with that gut wrenching feeling described above, this might be where you went wrong.
So, what's a good net margin %?
This varies a lot from business to business, so it's difficult to give a direct answer. It also varies based on whether you're a residential or commercial contractor.
There was a study of home builders carried out by NAHB carried out in 2009 which had some useful findings:
In this table, the profit % is the net margin - so about 9%.
You can use this as a rough benchmark for yourself. If you're above 9%, then things are going very well (make sure to double check your calculations). If you're below, then maybe there's some improvements you can make.
That being said, there's many general contractor businesses that operate with a 2-4% net margin.
Mark-up is your profit maker.
It's the percentage that you charge on top of the direct costs associated with a job. When deciding on a price, you should mark-up all of the direct costs of labor and materials.
Remember, you're only adding markup to the direct costs. This means that your markup must be enough to cover overhead, and also cover your desired profit.
There's a lot of theory behind how you should manage markup, and specifically what you should mark-up. But for now, let me suggest a ballpark figure of 25% markup on all direct costs.
This should be enough to cover your overhead, and also leave you with an acceptable net profit and net profit margin.
How to price correctly and be profitable
Now you know what your price should be made up of, and hopefully you also understand how to decide on a price using a solid methodology rather than guesswork.
There are still many things for you to practice. Estimating direct costs accurately when issuing a quote and accurately accounting for overhead is a tough job in itself. These are the business skills you need alongside trade skills to make a general contractor business successful.
How to apply this to your business
So the whole point of this article is to help you understand pricing so that you can ensure you are profitable - which, after all, is the whole point of business.
Here's some tips:
Increase your markup
This is probably the most obvious way to increase your net profit - you're simply applying a larger markup percentage to direct costs and thus charging a higher price to the customer.
Don't go crazy (lest your quote be much higher than other bidders), but increasing your markup is the easiest way to increase your net profit, so try that first.
Reduce direct costs
Once again, these costs are labor and materials directly associated with a job.
If you can reduce these costs you open up some options. You can either charge a higher markup so that the job price remains the same, but a higher percentage of the price is net profit. Or, you can keep your markup % the same, and thus lower your price for the customer (since you're now applying the same mark-up % to a lower direct cost amount).
Either of these can be attractive options, depending on the specific job in question. But before you can have these options you must learn to reduce and control your direct costs.
You should be careful with these things. Buying cheaper materials which are also lower quality might not necessarily be a good idea - it's more about finding the best bang for your buck.
The same can be said for labor costs. You don't want to treat your employees or subcontractors unfairly, because that will cause more issues than the increase to net profit is worth. But you do want to make sure that your labor costs aren't unreasonably high, and it's worth seeing what else is out there in terms of employees or sub-contractors.
Again, look for best bang for your buck.
Reducing your overhead might be a lot easier than reducing your direct costs. It won't have as large of an impact on your net profit, but it can certainly help.
Go through all of your overhead costs and see what can be reduced.
Can you get a better deal on insurance? Are you advertising, and is it worth the cost? Could you reduce accountant costs by hiring a cheaper bookkeeper to take on some of the work? Maybe a totally new accountant?
Could you get a more fuel efficient vehicle? Do you really need those new tools, maybe older models are just fine? Could you downsize to another office?
If you haven't done this before and don't usually pay much attention to overhead, then you can most likely find at least a handful of ways to save on overhead and thus increase your net profit margin.
We've barely scratched the surface
Hopefully you can use this advice to improve your pricing, and ensure that every job you take on will be profitable for you. Otherwise what's the point, right?
There's a lot more you need to learn though. Such as:
The pricing course that saved my business from disaster
There's a course created by Dan Perry called "The $100k Handyman", and it saved my general contractor business from crashing and burning.
The truth is that early stage general contractor businesses and handyman businesses are very similar.
Pricing principles in either type of business are almost exactly the same, and this course right here will teach you everything you need to know.
It goes above and beyond what I covered in this article. I consider it essential reading for any general contractor.
The $100k Handyman course will teach you:
I'm not sure for how long The $100k Handyman will be available. Dan doesn't want too many competitors getting their hands on this valuable information.
Click here to get your copy of The $100k Handyman and ensure the success of your business before it's too late.
The truth is, many general contractors never figure out pricing. They eventually run out of money, fail, and have to start the job search.
Dan Perry is the reason my general contractor business made it - and he can help you too.
Click here to checkout The $100k Handyman while it's still available.
Thanks for reading!