You’re in business to make money. No matter how much you love doing your trade, if you’ve gone out on your own to start your own company you want to end the day with cash in the bank. Properly calculating overhead and profit is critical to be sure you’re pricing out jobs correctly and have a sustainable business in place.
How much should you charge?
On every job you want to cover the costs of labor and materials, but that’s not all. You also want to ensure you’re covering your overhead and also making a profit.
- Overhead: the costs of operating your business. Includes costs such as insurance, bonds, office supplies, payroll, vehicle expenses, utilities, accounting expenses, etc.
- Profit: the amount left over after paying for the job costs and overhead.
Correctly calculating overhead and profit can mean the difference between a job making you money or costing you money. Fail to correctly calculate on a regular basis and you could find yourself with a business that’s in debt -- or doomed.
Overhead + Profit: Calculating Your Margin
A national survey from NAHB showed an average net profit of 9% and 10% overhead. That’s fairly close to the “10 and 10” of 10% overhead and 10% profit which is often considered industry standard. (Your overhead and profit may differ, but let’s use 10 and 10 as an example.)
With the 10 and 10 rule, your combined overhead and profit (also known as your gross profit or margin) would be 20%.
Here’s an example of the right way (and the wrong way) to determine what your markup should be to achieve a 20% margin.
Incorrectly calculating your margin
Many contractors assume that marking up their costs by 20% will bring them to a margin of 20%. But that’s not correct. Take a look at what a 20% markup does to your margin:
Job costs $10,000
+ Markup $2,000
Total price $12,000
Markup/ Total price = Margin
$2,000/ $12,000 = 16%
In this example, you’re left with 16% margin. If you take your 10% for overhead, that only leaves 6% profit for you/ your business.
Instead, here’s the right way to reach a 20% margin.
Correctly calculating your margin
If you want to reach a true 20% margin, you’re going to need to mark up your hard costs by 25%. Here’s why:
Job costs $10,000
+ Markup $2,500
Total Price $12,500
Markup/ Total price = Margin
$2,500/ $12,500 = 20%
A 25% markup will yield a 20% margin; that’s 10% for your overhead and 10% profit for your business.
Your margin may be less than 20% or (more likely) it will be higher. You may have operating costs that are closer to 30% and a pre-tax profit goal of 20%.
- In this instance, where a 50% margin is desired, your markup wouldn’t be 50%, it would be 100%.
- For a 30% margin, your markup is 43%.
Bookmark this markup vs margin chart so you can easily determine the right markup for your desired margin %.
Determining Your Individual Figures
If you’ve been in business for a few years, good record keeping will be your best bet in determining what your actual figures are.
- Add up total sales for the past year: calculate all sales
- Calculate all overhead expenses for the year: most overhead costs are fixed but your utilities may vary - find an average to use for utilities.
- Divide your average overhead expenses by your total sales to calculate your overhead percentage
If you’re a new business owner, you may have to do a bit of research to estimate the right figures. Talk to other contractors who are in similar industries to estimate annual sales figures, overhead costs, and job costs. Check in on contractor forums and see what other people are experiencing. As your business progresses keep accurate financial records and revisit your margin calculations as needed.
Tips for Success
Don’t forget to pay yourself. You’re not in business to work for free.
Your salary should come out of your overhead, not your profit. If your business is succeeding, you can give yourself a bonus out of your profit.
Avoid errors in direct cost estimates. Mistakes in materials costs can eat away at your overhead and profit, leaving you with nothing or even costing you money to complete the job.
Keep bid records. Bid records will help you analyze labor, material, indirect costs, and profit. If you don’t win a bid, find out what the winning bid was and keep track. Knowing what your competitors are pricing can help you price accordingly.
Embrace technology. Sure you can keep track of all your accounting and job costing using a calculator and spreadsheets. But in today’s modern world you also have highly sophisticated construction software at your fingertips that can make job costing and accounting a breeze. Ask your website developer if there are any tools that can be built into your contractor website to help you.
Determining the right pricing for your services can feel tricky. If you’re keeping good financial records and using the right formula, however, you can easily determine how much you need to keep your business operating and profitable. Being a good contractor is about knowing your trade, but being a good business owner means knowing your numbers, too.