Andrea Lyles, EA
Problem #2: You Only Take Direct Costs Into Account When Pricing a Job
Here is the video version if you don't like to read:
If you have this problem, then this will feel familiar: You ballparked the cost of materials and labor, then added a markup to price the job. You were SURE you made profit on the job, yet your bank account disagreed. This is a VERY common problem for contractors even if their cost of materials and labor were accurate. What can you do about it if this applies to you? 1) You need to see the big picture. 2) You need to know your numbers and use them.
First, big picture: You own a company. You have bills. The company has bills. There has to be enough profit built into your jobs to cover not just the direct costs of the job, but also the company's overhead expenses, YOUR time and labor (even if you're not on payroll), and activities that impact cash flow, such as asset purchases and paying down loans.
Let's get the paying yourself thing out of the way before moving on, because I know a lot of contractors have a tendency of putting this on the back burner, as if business owners are supposed to give their time and energy to their businesses for free. This is NOT sustainable. Why did you get into business in the first place? If you say it's so that you could have freedom, it's not exactly freedom if you are working without compensation, because that would make you a slave to your company. Seriously sit down and think about what your time and work is worth. What would you expect to get paid if you went to work for another contractor? Let that be the bare minimum you expect from your own company. Remember, you are the boss, so ideally, you should be making more than you would make working for someone else. You may reason that you need to build up to that point, and while there may be some truth to that, it won't happen if you continue to run business as usual.
Now let's talk about the overhead expenses. This is where we need to mix seeing the big picture with knowing your numbers. Simply put, your GROSS profit is the amount that's left after you subtract direct costs from your sales or revenue. Most people do have a positive gross profit. Your NET profit is what's left after you subtract the nice long list of additional expenses, such as advertising, bank fees, office wages, insurance, interest, office supplies, professional services, travel, and vehicle expenses from your gross profit. If the resulting number is negative, then you have a net loss rather than a net profit. This is where we usually see construction companies running into trouble. (This can all be seen on your income statement, aka profit and loss statement).
If you have a net loss, what can you do differently? Well, it starts with having the right data. If we start from the top down, let's ask the following questions:
Do I build job budgets before I send out an estimate? If not, then you're missing a crucial step. All direct costs--materials, labor, subcontractors, equipment rental--should be outlined in the job budget. If you will personally be working on projects, this includes what you expect to be paid, even if you're not on payroll. (If your work is indirect, then it should be accounted for in overhead, which is discussed later on in this post.) With the technology available today, there is no reason to not to have accurate budgets. If you are just starting out, you can use something as simple as a spreadsheet to make quick calculations. But if you really want to up your game, use a project management software. (Our favorite? JobTread)
Do I track actual expenditures against my budgets? This is important because you may be spending more money on materials than you expected. Small items can really add up. Also, the cost of labor may change due to any number of variables, such as weather or other unforeseen circumstances. The amount of markup or margin you figured won't matter if you're consistently falling short in estimating your direct costs. You need to know where you're bleeding money so you know where to stop it.
How much can I increase my profit margins and still retain a reasonable amount of clients? If you're charging what you used to charge 10 years ago, there's a serious problem. At a minimum, your price increases should reflect the changes in material prices as well as inflation. Consider the market and what your competitors are charging, but don't let that be the end-all be-all. If you position yourself correctly, you may find you can move your company to serve a higher-paying customer base, which would mean you could make more money doing less work, and you get yourself out of the race to the bottom. You may even find that your current customer base can handle the price increases.
Do I keep proper records of business expenses? This is important before moving on to the next couple of questions because you need to know what you're spending on each type of overhead expense in order to make any meaningful decisions. AND, well...proper books and records are required by the IRS. Here's a concise IRS article showing what records should be kept: https://www.irs.gov/businesses/small-businesses-self-employed/what-kind-of-records-should-i-keep If you need help in this department, please reach out, since bookkeeping is our core service.
What are my biggest expenses? Is it possible to trim those expenses? If you have not kept good records, it may take a few months to build enough historical data to start seeing a good picture of where your money is going. Then you will be able to decide if adjustments need to be made. Consider if the money you're spending is contributing to your business goals. If you don't have a good handle on your expenses, you can list the expenses in order of importance and budget for the most important ones and make sure they are covered before you spend money on the categories that are not essential. See our previous article for tips on budgeting.
Am I building overhead costs AND business profit into my jobs? If there is little historical data, then you may start with a simple approach, by estimating what your monthly overhead costs are as well as what you would like to get paid per month. Then, roll those costs into future estimates/quotes considering the number and size of jobs you typically do per month. If there is historical data you can use, then you will want to calculate your overhead rate. (Note: If you are not an employee of your company, you will not see your own pay on the profit and loss statement, so make sure to manually include this in your calculations of overhead or cost of goods sold, depending on your role in the company.) There are a variety of metrics you can measure your total overhead against, such as total sales, total labor hours, total cost of goods sold, etc. The concept is much more easily understood by watching a video rather than reading about it, so here is a good reference: https://youtu.be/qrnTwV2zbPM Even though it refers to manufacturing, the same principles apply to construction. Once you figure your overhead rate, include this as a line item in your estimates/quotes. Your business profit will be additional and will vary depending on factors such as sales and project volume as well as business goals. If you're using a spreadsheet or project management software, then it's very easy to play with the profit margins to arrive at your desired amount. Your overhead rate and target profit margins are not static numbers. They need to be periodically reevaluated as your business evolves.
Bonus: Am I doing proper tax planning? If you've been incurring a net loss, then you may not have given this much thought, but as you become more profitable, it will be important to apply proper tax planning so that you are not paying more in taxes than you need to. This may involve a number of things, such as choosing the best entity type, making wise asset purchases, contributing to retirement funds, etc. Again, if you need assistance with this, we offer tax planning as an add-on to our core bookkeeping services.
Now, what if you have a net profit but there's still no money in your bank account? That means the money is being used for something other than cost of goods sold or overhead expenses (operating activities), such as asset purchases (investing activities), paying down on liabilities (financing activities), or distribution of equity (financing activities). (Examine your statement of cash flows if you want to see these categories in action.) As a simple example, let's say you had $10,000 in net profit and your purchased a $10,000 work truck. Well, basically, you exchanged one asset (cash) for another (truck), leaving the cash at $0. Or, if you purchased the truck with a loan, then you'll be spending money each month to pay down the loan (a liability). See why business profits are important? And why you might need more than you thought you did? The profit will be what allows your business to expand and grow, but, again, you have to use it wisely.
This was just a very brief, high-level view of what should be included when pricing jobs. When you have accurate data, budgets, and reports, then you can really start making some headway in moving the needle in the right direction. That's why we, at Contractor's Keeper LLC, consider bookkeeping to be at the core of gaining financial clarity. If you'd like to have a free 30 minute chat with us, please book your initial call with us to see if our services are a good match for you and your business.
In the next blog, we will discuss the third problem: not delegating.
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