In his book Professional Remodeling Management, REMODELING contributor Walt Stoeppelwerth wrote that the No. 1 cause for failure for remodelers is "not knowing the true economics of the business." He penned those words nearly 20 years ago, but unfortunately, they still ring true today: Too many remodelers are miscalculating their prices and losing serious money because of it.
Your total sales revenue has three components: direct costs, indirect costs, and profit. Understanding each of these and their interaction are the first steps to becoming a truly successful remodeler.
"Anything I can attribute to doing a job, I want above the line, as part of cost of goods sold," says Jud Motsenbocker, owner of JUD Construction in Muncie, Ind. Obviously, this includes money for materials and what you pay your field employees and subcontractors. But there are other items to consider, as well. For example, if you have a production manager, at least part of his salary should be a direct cost, based on how much time he spends out of the office. Ditto for a portion of your salary if you do some work out in the field.
Labor burden for field employees should be counted as a direct cost as well. Because of Social Security, insurance, and other costs associated with having employees, your field crew costs you much more than what you pay them as an hourly wage. The most foolproof way to ensure that labor burden is covered is to include it above the line.
It is vital that you be meticulous when calculating direct costs for a job. It's easy to forget little things like delivery charges, but little things add up, and they come out of your profits.
Any payables or payroll expenses that can't be attributed to production are indirect costs, commonly called "overhead." Rent and utilities for your office space, pay and labor burden for office employees, and your trucks and associated expenses are examples of overhead costs.
Tom Poulin, a 25-year veteran in the industry, says that the biggest mistake many remodelers make is not knowing what their true overhead is.
"Some owners don't have a line item for their salary and just take what's left over," says the owner of Poulin Design Remodeling in Albuquerque, N.M.
Motsenbocker, who opened his business in 1968, says he often sees similar problems. "Everything you do, you should be paid for," he says. That means if you're making sales calls in the evenings and on the weekends and working 50 or 60 hours per week, you should set your salary accordingly.
Calculating overhead isn't all that difficult; simple addition and multiplication will do it. The hard part is being thorough.
If you sell enough to cover direct costs and overhead, you've broken even, and hopefully taken a decent salary home, too. But that's not enough. You need money on hand for the proverbial "rainy day," and to invest back into your business to grow it.
The amount of net profit you choose to add to your selling price is entirely up to you, but 10% of sales is a pretty good benchmark. If you balk at that number and think there's no way you can survive in your market with those prices, well, you'll never know unless you try.
Markup & Margin 101
Taken as one, the money you take in to pay for overhead and the money you make as profit are called "gross profit margin." A company whose overhead costs are 30% of sales and whose net profit is 10%, for example, has a gross profit margin of 40%. These percentages are yearly totals, and each job you sell should reflect this ratio.
In Stoeppelwerth's book, he recommended applying a markup to the direct costs of every job to recoup overhead expenses and turn a profit. In a familiar example, he suggested a 67% markup—that is, multiplying direct costs by 1.67—to end up with a gross profit margin of 40%.
Somewhere along the line, however, people got confused, and many to this day multiply by 1.4 to achieve a 40% margin. This second calculation is incorrect because it treats the gross profit margin as a percentage of the direct costs, not the selling price.
You can still use a multiplier to mark up direct costs (see chart, below). But to easily calculate the correct selling price for any margin—and to fully understand the concept—we recommend using a divisor as part of a simple formula: Take the decimal value of your margin, subtract it from one, and then divide it into the direct costs of a project.
As you can see from the sample calculation on the right, if you have a 40% margin and a project with direct costs of $60,000, you should charge your clients $100,000. This makes sense: If your margin is 40% of the selling price, then direct costs must be 60%, and $60,000 is 60% of $100,000.
Now look what happens when you misuse the multiplier. Take that same job with $60,000 of direct costs, and multiply it by 1.4. You end up with a final selling price of $84,000. Sixteen grand is a pretty big difference, but it gets even bigger when you realize that it includes your profit on the job, which, had you priced correctly, would have been $10,000. Plus, you actually took a $6,000 hit to cover your overhead. That's a mistake you simply can't afford.