Profit Margin versus Markup in Construction
In the world of construction, many estimators and business owners are not as profitable as they might think. While speaking with thousands of contractors every year, the single biggest accounting mistake we hear over and over is the term “markup” and “profit margin” being used interchangeably while estimating construction projects and this is leaving many contractors with a lot less profit on the books each year. Be honest, do you know the difference between profit margin and markup?
If you’re shrugging your shoulders or feel a bit queasy thinking of your answers, you’re not alone. For many professionals just like you, a better understanding is required of important terminology and proper business accounting calculations to ensure you’re charging what you’re worth and not leaving money on the table.
Let’s Talk Terminology
The root of this particular profit problem is the mix up of terms “margin” and “markup” and wrongly using them interchangeably to mean gross margin. By grasping the difference between these terms, you can bolster your bidding process and so improve profit and reduce risk.
Margin and Markup do have something in common; each helps to set prices and measure productivity. However, they reflect profit differently, and with a keen eye always on the bottom line, it’s critical to appreciate the difference between margins and markups.
So, first … English class. Understanding these terms will help you clearly see the difference between margin and markup.
Job costs capture everything needed to do the work, including labor, materials, leased equipment costs, projected capital costs (if borrowing money for the job), bonding premiums, permits, and fuel, and other supplies. Some businesses refer to this as Cost of Goods Sold (COGS), which include the expenses that go into making your products and providing your services. Calculating COGS could include materials and direct labor costs.
Overhead includes the bills and expenses not included in job costs that must be paid to operate your business. It may include items such as office rent, office support staff, types of insurance, equipment, tools, accounting, bookkeeping, legal fees, owner’s salaries, and outstanding debt payments.
Revenue is the income earned by selling products and services. Revenue is the top line of an income statement and reflects earnings before deducting costs.
Net profit is what remains after job costs and overhead are subtracted from the price. Net profit can be used toward capital investments (i.e., additional office, new equipment or machinery). Experts say that a healthy business should be able to count a net profit of at least 8 percent.
Gross profit is the revenue left over after paying the expenses of making your products and providing your services. Gross profit is revenue minus COGS.
Markup is the difference between the cost of materials or services and the sales price you’d charge for them. The figure is always based on the cost of the job. In brief, markup is the sales price minus the job costs. Markup shows how much more your selling price is than the amount sale items cost you.
Markup percentage is the percentage difference between the actual cost and the selling price.
Margin, or more accurately a gross margin, is your gross profit on a job and is a percentage of the sales price. It shows the revenue earned after paying the COGS as a percentage of the gross profit. While a markup is always based on job costs, a margin is always based on sales. Think of it as margin is the sales price minus the job costs and minus overhead allocation.
Gross margin percentage is the percentage difference between the selling price and the profit.
By now you’re surely wondering “how does this play into profitability?” Well, if you believe that a markup of 20% on your project will result in a 20% gross margin on the income statement, then you’re wrong, and staring down an expensive mistake.
It’s time to keenly focus on the crux of the issue we set out to solve – knowing the difference between the Margin and. Markup and using the method that is right for you.
Respecting Perspectives: Estimator vs. Owner
Not to make the issue more complicated, but to choose the right method you must respect the difference of perspectives between the owner and the estimator. Without that appreciation, the miscommunication and misunderstanding of all those terms will likely persist.
Estimators are typically required to calculate cost, add on to that cost by some factor to make money, and arrive at the price to bid. This way of thinking leads estimators to often use the markup method – in that “add on” step.
Owners need to review and evaluate past performance to make sound future business decisions, especially those that involve staffing and investment. Thinking in this way, gross margin is the method of choice. Owners have a gross margin they’ve built their budget and focus on it year-round. It’s their goal to hit, and how they’ll measure business success and profitability.
The varying perspectives have these pros asking different questions. The estimator is looking ahead asking “How much markup should I do?” while the owner is looking back and asking, “How much money did we make?” These questions will not provide the same answer. Fairly small adjustments in markup lead to big changes in gross margin. For example, increasing your markup from 1.2 to 1.3 equates to your margin going from 17% to 23%!
The miscommunication stems from that difference of perspectives. Gross margin is the natural language of the owner, whereas markup is the natural language of the estimator. Yet, everyone needs to be thinking of optimal profitability – and for that, the Margin Method is your best bet.
Calculations & Conclusion
“But I love the markup method!” you cry! After better understanding the margin method and its impact on determining your true profitability, you’ll have a change of heart. That is, you’ll like making more money on every project than you like using the markup method.
Yes, it’s true that you can use a markup to make a profit on a job, but without proper calculations, you may fall short of your margin goal and leave money behind that you indeed earn!
Similarly, the wrong calculations are possible when contractors use gross margin incorrectly. This leads to erroneous estimates and lost profits.
So, since we survived English class above … let’s now tackle Math class and recap our key terms and review some calculation examples you can use to improve profitability and project success.
Markup is the multiplier you use against your direct field cost to arrive your job price. Markup is easy to calculate, unless the estimator has buried their costs (never recommended if you expect to know true profitability!).
Here’s your calculation: MU = P / DC
Markup (MU) equals Job Price (P) divided by Direct Field Cost (DC)
Gross Margin is the portion of sale contributing to overhead and profit. Calculate it by subtracting the direct field costs from the job price, divide that by the job price, then multiply by 100 to identify as a percentage.
Here’s your calculation: GM = GP / P
Gross Margin (GM) equals Gross Profit (GP) divided by Job Price (P)
Keep in mind that there’s a big difference between thinking you’re making 20 percent net profit on a job when in reality it’s closer to 12 percent or even lower. It’s important that owners know their overhead costs and use that knowledge to set bid amounts accordingly. When your margin is too thin, then the company is vulnerable to unanticipated issues with materials, equipment, weather delays, and a collection of problems that occur on any given job.
Are you wondering if there is a formula for translating the two? Yes!
You can calculate the gross margin from the markup using: GM = 100 x (MU – 1) / MU
You can calculate the markup from the gross margin using: MU = 1 / (1 – GM/100)
Give it a shot yourself, what percentage of gross margin do you want? Subtract that number from one. Then, divide the estimated job costs by that figure.
For example, if you want a margin of 35 percent, then subtract .35 from one, resulting in .65. Then, divide the estimated job costs by .65. That will give you the amount needed to reach a sale price with the correct gross margin: $6,500 / .65 = $10,000.
Let’s consider this in another construction business scenario. Say your total forecasted sales for the year are $1 million and your annual expected overhead costs at that level is $80,000. That’s an 8 percent cost of overhead – you need to add on more than 8 percent to the cost of the job to simply break even.
Some owners who take this close look may see they’re overspending on overhead or are not setting aside enough to cover office rental costs. These insights may obviously drive business decisions that improve the bottom line, but we’re going to keep our focus on bidding…
Take another example: You are bidding on a job that will cost $200,000 to complete with materials, labor, and equipment. You plan to bid $250,000. At 8 percent, your overhead allocation for this job would be $20,000.
A good (accurate and profitable) bid is not about adding on a standard percentage to job costs. You must be precise about your business’s financial needs and as exact as you can be about your costs and revenue goals. Knowing the difference between margin and markup can certainly go a long way toward improving your bottom line!