We tend to think of business success along the metric of money and generated revenues. Construction contractors are too often caught up by the vanity of the top line revenue.
Top line revenue is the easiest to understand as it’s the first line on your profit and loss statement – your revenue is what clients have paid for the goods and services you’ve provided. The bottom line, your net profit, is typically much more important than your revenue.
Top line revenue is sometimes referred to as a vanity metric – it’s a point of comparison for other people to evaluate your business. When construction service businesses increase sales to drive up revenues, what ends up happening is that the increased project volume can negatively impact net profits if efficiencies and systems are not in place to handle the spike in project volume.
Let’s dig a little deeper.
Construction service businesses essentially act as a pass-through for finished goods, material and sub-contracted labor, these expenses are known as Cost of Goods Sold (COGS). Think you’re a million-dollar construction service company? Think again. Reducing revenues by COGS gets you to Gross Profit. Greg Crabtree, author of Simple Numbers, Straight Talk, Big Profits, takes it one step further, factoring direct labor to arrive at the Contribution Margin. Crabtree defines direct labor as “labor that is directly responsible for product or service delivery”. In our roofing company, our project coordinator and foreman we employ fall into this category of direct labor. If you as the owner also contribute hours to deliver the product or service, your wages need to be included in direct labor. According to Crabtree the contribution margin is the true economic engine of your construction service business.
Crabtree’s example below shows that a $20 million-dollar construction service company is effectively a $1.85 million company. Take a little closer at the bottom line comparison. The service company generating a top line revenue of $3.75 million arrives at the same Gross Profit but surpassing the seven-figure large construction service company with a 14% net profit.
The more a company spends to generate a designated profit, the more vulnerable it is to minor cost shifts. Profit margin more accurately reflects long-term profitability and a business’s vulnerability to sudden increases in fixed costs (insurance, office expense, etc. – it’s important to note that as an owner, your salary/admin wages should be calculated into fixed costs. This is separate from your direct labor wages.) It’s pertinent to track profit margin in order to implement strategies, to keep profit margins as high as possible.
Trimming the Fat
A minor decrease in costs will improve profit margin more than a comparable increase in total sales. Case in point, we have been faithful to the same material distributor for the last 7 years and decided to do some price comparison with other distributors in the area. We were astonished to find that prices with other distributors came in at an average 10% below what we were currently paying for materials. So, imagine if we are ordering $500,000 in materials annually, that is $50,000 increase to our bottom line! We were able to negotiate scantly better terms with our current distributor, thus have moved a majority of material orders to another distributor which will positively impact our bottom line.
Instead of increasing sales, think about increasing price.
A bit of wisdom that originally came from Rafi Mohammed, the author of 1% Windfall. Think about the price you charge for your product or service now. What would happen if you increased your price by a mere 1%?
In our case, if we sell a roof for $10,000 all things remaining constant (labor, insurance, materials, etc.), we now price that same roof for 10,100. That mere 1% increase of $100 goes straight to the bottom line. Therefore, if we average 100 roofs per year that’s a $10,000 increase in net profit.
Net Profit General Rule of Thumb
Most construction contractors are not provided with guidance when it comes to the amount of net profit we should be setting toward profitability goals. Somewhere along the line the old 10 & 10 (or 20% markup) rule became an industry standard, which has led to many contractors spinning their wheels. At 20% markup, this only yields a 16.66% profit margin, this profit margin leaves little room for fixed costs. Barely enough to arrive at a healthy net profit for a business to survive.
For a business to be operating successfully the target net profit is between 10%-15% before taxes. Crabtree sites:
- 5% or less of pretax profit means your business is on life support
- 10% of pretax profit means you have a good business
- 15% or more of pretax profit means you have a great business.
Reverse engineer your business’s best price for the project. Every company has different operating expenses, by backing into a profitability goal you can arrive at your price. This is when the top line revenue goals will provide valuable budget forecasting. By charging your best price, you will be able to hire the talent and skilled labor necessary to deliver a superior finished product and experience to your client.
Too much emphasis is placed on selling more jobs to arrive at a vanity driven arbitrary revenue milestone. Instead focus on reducing costs and increasing price, overtime you’ll be running a more profitable business.
It’s not about selling more jobs it’s about selling more profitable jobs.