Using Gross Margin Correctly

Yesterday markup – today gross margin. Let’s look at using your gross margin to calculate the correct sales price for your work.

Gross margin is your gross profit as a percent of your sales price. Gross profit is what is left after you pay all direct job costs. You use your gross profit to pay overhead and your profit. Net profit is what you have AFTER you pay your overhead.

You can calculate your gross margin like this: If your gross profit on a $100,000 job is $25,000, your gross margin is 25%.

Let’s assume your company has an annual sales volume of $150,000, overhead is 25% ($37,500) and we make an 8% Net Profit. Our gross margin is 33% – the 25% overhead plus our 8% net profit.

A gross margin of 33% simply means that your total overhead and profit equals 33% of your total sales – and your job costs are 67% of your total sales.

Let’s use the same estimated job cost we used in the markup scenario and calculate our sales price using gross margin.

Our gross margin is 33%, and the estimated cost of the job is $8,755. To calculate the sales price using gross margin, you have to divide your job costs by their percent of total sales. Since our gross profit is 33% of total sales, our job costs are 67% of total sales. so:

$8,755 / .6700 = $13,067 sales price

There are two mistakes that are easy to make when using gross margin. If you divide your job costs by your gross margin of .33, you’ll end up with a sales price for your work of $26,530, which is really high. You’ll probably catch that mistake.

The more common mistake is to multiply job costs by the gross margin, and add the result to job costs. If we do that, $11,644, and that’s believable. It’s wrong, but believable. The calculation: ($8,755 x .33) = $2,889. $2,889 + $8,755 = $11,644.

When you do that. you’re $1,423 short of what you need for gross profit.

Incorrect Calculation –
Sales price – $11,644
Job Cost – $8,755
Gross Profit – $2,889
Gross Margin – 24.8% (2,889 / 11,644)

Correct Calculation –
Sales price – $13,067
Job Cost – $8,755
Gross Profit – $4,312
Gross Margin – 33% (4,312 / 13,067)

If your business needs a gross margin of 33%, you need to use the correct calculation or you’ll be in trouble. Subtract your gross margin from 1 (1 – .33 equals .67), and divide your estimated job costs by that figure.

Unless there is something incredibly unique about your business (and there usually isn’t), these are the gross margin ranges contractors usually fall within:

• Remodeling Contractors    =      34% – 42% +
• Specialty Contractors   =        26% – 34% +
• New Home Builders    =       21% – 25% +

It’s very easy to get confused when you’re working around with gross margins. Our next article explains another common mistake made when trying to work with both markup and gross margin to calculate your sales price.

Part 1 – Markup vs Margin
Part 3 – Markup or Margin . . . Which is Better?