When I do seminars and classes on markup, I ask the following question: "You should never try to be competitive, you should always try to be___? The answer, of course, is profitable. You must make a profit to remain in business. If you don't make a profit, your business won't be around long. Then, you will be faced with the task of trying to pay off a pile of bills—assuming you do the honorable thing by repaying your debts instead of declaring bankruptcy.
Either case is far more work and heartache than learning the basics of how to establish the correct price for your work. Once learned, you can put these principles into action and become one of a select group who makes more than just a living in the wood flooring business. In order to help you understand the nuts and bolts of determining markup, this article will look at the specific scenario of a new business.
Let's say that, after working for other companies fora number of years, you have decided it is time to start your own hardwood flooring business. In fact, you have done your homework and already have these key elements in place:
You are almost ready to take your first sales call for your new company. But, first you need to ask yourself (and answer) two questions:
1. How much should the markup be in order for my new company to arrive at the right sales price?
2. What is the margin and the percent of margin for my new company?
A large majority (more than 90 percent) of people in the floor covering business cannot answer the two above questions. Consequently, they sell their work for less than they should and end up going broke. Thankfully, it is simple to educate yourself to correctly identify the markup you need to cover job costs, overhead expenses and meet your goal of a minimum 8 percent net profit.
How do you make a profit in the construction business? This question has been the focus of national construction-related magazines and conventions for years;and, if you follow the thinking of many, it is all about how well you do your jobs. We all have heard a company say: "We do quality work!" That brings us to another question: If getting better at production is the way to make money, why do so many fail.
In reality, getting better at production and improving quality is not the answer to financial success. The answer is simply charging more for the work you do. It's all about markup.
Markup is a number that, multiplied times the job cost, will yields sales price that will cover all job costs, over head expenses and a profit. To determine your markup, the first thing you need to do is establish your overhead expenses for last year or, if you are a new company (as in this scenario), what you project your overhead expenses to be for the coming year. The number you come up with should include both fixed and variable overhead. Then, you need to convert that number to a percentage of the total revenue expected. Subcontractors normally have overhead expenses in the 22 to 38 percent range, with an average of 26 to 30percent.
Once you have the figure for your overhead expenses, the next step in determining your markup is to set a goal for profit. Your goal should be no less than 8 percent (as in our example scenario), and preferably should be 10 percent or more. Until you have set and reached that goal, your company will struggle along, making a profit one year and losing money the next. When you finally hit 8 percent profit, your company will achieve new found stability, having the money it needs to consistently pay bills, and you can focus on running your business without the distraction of financial matters. This is why setting a goal for profit should be the top goal in your company.
With the number for your overhead expenses established and your goal for profit set, you can calculate your markup and set the correct selling price for your work. First, you need to determine the volume of work your company has done or will do for the same period of 12 months. If you are new in business, you will have to make an educated guess. In our example, you predicted that you will do $136,500 in sales: 28 (number of jobs per year) x $4,875 (average sales price) =$136,500. If you assume $136,500 in sales and divide your overhead by your total projected sales, you will get your overhead percent: $3,092 (monthly overhead) x 12 (months in year) = $37,104 and $37,104 ÷ $136,500 = 27.18 percent. If you have been in business for a period of time already, you can simply review your company's past statistics to determine your projected sales for the coming year.
Next, you need to calculate your projected net profit goal of 8 percent, which will be 8 percent of $136,500, or $10,920. Now, subtract your overhead and profit from your total projected sales and you get job costs of $88,476 ($136,500 $37,104 - $10,920 = $88,476). Job costs refer to the money you have to install the jobs sold. The formula to arrive at the correct markup for your company is:
Sales ÷ Job Costs = Markup
$136,500 ÷ $88,476 = 1.5428 or 1.55
Now, I can hear the screams of anguish and disbelief from all quarters: "Nobody can use that markup and sell a job in this town. I can't use more than a 10 percent markup; that's all I can get." The math, however, is correct, regardless of how many times you calculate it. More importantly, however, you now see why so many companies go broke—most contractors do not charge enough.
If you think you can't use the markup numbers calculated here, you are right. One markup doesn't work for everyone. In all probability, you are undercharging your customers for your work. Where do you think that will lead. Remember that this is a hypothetical case showing the correct math formula to arrive at the correct sales price for your work. It all hinges on your overhead expenses and how much profit you want to make. We all have different expectations, desires and overhead expenses; therefore, we all have different financial needs and goals for our companies.
Still not convinced. Then, answer this question: If 90 to 96 percent of all contractors will not survive 10 years in this business, and if you believe Dun & Bradstreet when it says that most contractors go broke because of lack of profits (i.e. …they don't charge enough), then if you try to be "competitive" by pricing your jobs at or close to what you think "your competition" is charging for their work …what does that make your numbers.
Keep in mind that we are talking about companies that do $2.5 million dollars in sales a year or less. Most of the larger,profitable companies know their numbers well enough that they seldom fall into the trap of trying to be competitive. Plain and simple, they know better.
Every once in a while we hear about a contractor taking a job for less than his markup dictates because, "I must be competitive" or "I have to keep cash flowing into my company." My answer to each excuse is the same: No, you don't. The bottom line is this: you have to make a profit, or you will not stay in business.
There are contractors out there who use margins rather than markup—and that is fine, as long as you know the difference between the two.
• Margin is the difference between what you sell a job for and what it costs you to do the job. In other words, it's the total amount of your overhead and profit.
• Markup is your job costs times a number that allows you to sell a job at a price that covers your job costs and overhead and also provides you with a profit.
Now, let's calculate the answer to question 2, from the beginning of the article, about how to determine margins.
Our margin is our sales volume minus job costs or $136,500 - $88,476 = $48,024. You also can use the formula of overhead+ profit = margin and you will arrive at the same number: $37,104 + $10,920 =$48,024. Our percent of margin is our margin ÷ sales ($48,024 ÷ $136,500 =35.18).
Be careful not to put too much emphasis on either the margin or percent of margin that you arrive at here. Normally, margins are used to compare like businesses. If you know others in your business who have numbers you can use as a comparison,use them. If you don't, I would recommend that you stay focused on fine tuning your own numbers. In reality, the only number that really counts is your net profit after the job(s) have been completed.
Let's take a look at a couple of problems that frequently come up when contractors with a less-than-thorough understanding of margins try to use this approach to arrive at a sales price for their work.
The problem I most often hear occurs when a contractor thinks that a 30 percent margin and a 1.30 markup are one and the same. They're not. A margin of 30percent for a sale of $10,000 is $3,000. That leaves $7,000 to do the job, right. Let's take that same job cost of $7,000and hit it with a 1.30 markup (1.30 X$7,000). That gives us a sales price of$9,100. That's $900 less. It takes a 1.43markup to get a sales price of $10,000. You can see how a contractor could lose money if he used these methods as though they were interchangeable.
Then, there's the contractor who talks about the big margins he makes. He neglects to tell you about the small dollars he's working with. He thinks that a 30 percent margin is good. If you have annual sales of $975,000, then a 30 percent margin is a fair number. But, what if he's only doing $175,000 in sales for a year. With a 30 percent margin, he'll only have about $52,500 to pay all his bills (including his own wage) and make a profit for the year. Again, you must remember that profit isn't something that the owner stuffs in his pocket. Profit belongs to the company. So $52,500 isn't a good number. Something or someone will be neglected.
Some of you may have just discovered margins and think that this is the more sophisticated way to go. While margins may be "trendy," and you may indeed turn heads, the reality is that using margins can get you into as much trouble as using someone else's markup. There's no correct margin for everyone, just as there's no correct markup for everyone. You have to carefully figure your own margin. The most successful contractors are the ones who stick to the K.I.S. (Keep It Simple) method of doing business. Don't get hung up on dealing with percentages. Deal with actual numbers, and you'll find your business will be simpler—and more profitable.