Like many of you, I read industry magazines to keep up on new ideas. Much of what I read is good, but a recent article titled Strategies for Increasing Your Markup* requires a comment.
The premise of the article is that once you realize your markup is too low, it needs to be increased incrementally. For the life of me I can’t figure out why.
Increase Markup Incrementally?
If you’re selling jobs at a loss, you should price your next job to be profitable. If that requires increasing your markup from 1.20 to 1.50, then increase your markup to 1.50. If raising your markup requires improving your sales skills, then improve your sales skills. Whatever you do, don’t continue selling jobs at a loss because you think your markup needs to increase incrementally.
If you sold a job to Joe and Mary at a 1.20 markup and lost money, why can’t you price the next job to Bob and Sue at a 1.50 markup? Your clients don’t need to and shouldn’t know what markup you used to price your work; your markup is proprietary information.
Is the concern fairness? Joe and Mary got a fantastic deal on their remodel, at your expense, but that doesn’t mean you have to keep giving away the farm. Now that you know better, everyone from now on needs to pay a fair price. A fair price is the price you need to cover all job costs, pay your overhead expenses, and make a reasonable profit. That’s fair to everyone.
Use Your Own Markup
The author presents many examples on how to incrementally increase your markup, stating that the figures used are actual figures from clients and are not her recommendation. She goes on to suggest that benchmark figures for margin can be found in industry reports.
The example assumes a company has been using a markup of 12.5% (multiplying job costs by 1.125) and their goal is to increase their markup to a whopping 19%. Folks, unless they are doing some fancy accounting, they’ll keep losing money at 19%. I don’t know why she didn’t use realistic figures in her example.
In my experience, if you’re a remodeling contractor using a markup of less than 50% (1.50), you’re losing money. Specialty contractors need to be using a markup of at least 35% (1.35). New home construction, 26% (1.26).
You should do your own math, calculate your own markup, and use that number across the board on all jobs, big or small. To calculate your markup, look at your P&L (Profit & Loss statement). Properly compiled, your P & L will reflect your cost of goods sold, your expenses (overhead) and your net profit from all the jobs you have sold, built, and collected over the last 12 months. Your markup is what pays your overhead expenses and provides your profit.
Having looked at literally hundreds of P & Ls over the last 22 years, I can tell you that most aren’t compiled correctly. The simplest and best approach to categorizing costs is this: if an expense can be attributed to one job and one job only, it should go into the Cost of Goods Sold section. If an expense can be attributed to two jobs or more, it should be considered an overhead expense.
I have heard CPAs and others say that you should put as many of your expenses above the line as you can. That line is what separates Cost of Goods Sold from Gross Profit (which is your overhead expense plus net profit). Everything above the line is Cost of Goods Sold, everything below the line is Gross Profit. Why do they recommend putting as many of your expenses above the line, into Cost of Goods Sold, as possible? Because you’ll calculate a lower markup. That’s what you do when you’re focused on price.
Again, your markup is your overhead and profit, that’s everything below the line. Your estimated cost is Cost of Goods Sold, that’s everything above the line. If you put expenses above the line in your P&L that you don’t include when you estimate a job, your markup is too low. You’re going to lose money. The Cost of Goods Sold in your P&L needs to be directly comparable to the job costs you estimate.
Using a Variable Markup
A variable markup, sometimes called a sliding scale markup, is when some jobs are priced at a lower markup than others. The plan is that you’ll use a higher markup on the small jobs, and a lower markup on the big jobs.
In almost all cases that I’ve seen, using a variable markup gives the salesperson the freedom to lower the markup when they want a lower price, making it easier to sell. The writer commented in the article that contractors panic when their markup gets too high. If you fall into that category, your focus is on price and focusing on price will take you right out of business. Your focus should always be on estimating the job accurately, applying the correct markup for your company and making a net profit.
When you lower your markup, you leave money on the table. Does lowering your markup lower the cost of the job? Does it lower your overhead expenses? Does it lower your profit needs? No, it doesn’t. It only lowers the price your client will pay.
Be Profitable
You’re in business to provide a service and make a profit doing it. You are not in business to play games with math trying to create a sales price that might and might not allow you to make a profit on your jobs. Moving things above the line to lower your markup or adjusting your markup on jobs based on job size or the time of year or anything else is game playing.
Evaluate every job after it’s complete so you know how accurate your estimates are. When you compare estimated costs to actual costs, called job costing, you know your error factor. When you add that error factor to future estimates, your jobs become more profitable.
You should achieve a net profit of no less than 8%. Our coaching clients that make at least an 8% net profit can make a decent salary from their company, provide for their family and their employees, and can weather financial storms or the occasional bad job. If you aren’t netting an 8% profit, frankly, your chances of going out of business increase.
Keep it simple. Calculate your markup and use it. If it needs to be increased, then increase it, today. Focus on getting your jobs built at the estimated cost so you can see a minimum 8% net profit. And be careful about what you read.
* The article is here, it requires registration and/or login.
The knowledge and experience Michael Stone gained in his 60+ years in construction has helped thousands of contractors improve their businesses and their lives. He is the author of the books Markup & Profit Revisited, Profitable Sales, and Estimating Construction Profitably, and is available for one-on-one consultations.
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