You have to understand the critical relationship between direct costs, gross profit, and selling price to make the right amount of money on any job. By Sal Alfano.
Even after remodelers have the concepts of "markup" and "margin" down pat, confusion often remains about how to calculate gross profit and how the resulting percentage relates to estimated costs and selling price. This article explains the critical relationship between estimated costs, gross profit, and selling price.
Calculating gross profit
Nobody who wants to stay in business for long can price a job at cost. In addition to the cost of materials, labor, and subcontractors for each project (direct costs), a construction company has non-job related expenses (indirect costs or overhead) that must be included in the price. The selling price of a project should also include net profit, which every business needs. Together, overhead and net profit comprise gross profit, which is typically expressed as a percentage of total revenue.
The simplest way to find the overhead percentage is to first calculate the total dollar amount of overhead. To do that, add up all non-project related expenses. These could include, but aren't restricted to, the owner's salary (assuming he's not in the field full-time), bookkeeping help, rent and utilities, tools and equipment, office supplies, vehicle repair and fuel, marketing, phone and pager, and legal and accounting help. Then divide that number by the total revenue. To find gross profit, add the targeted net profit percentage to the overhead percentage.
Finding the selling price
Once you know what your gross profit margin is, you can use it to arrive at the proper selling price. Unfortunately, however, it's easy to use the right gross profit margin to come up with the wrong selling price. It seems that adding 25% to your direct costs would give you a selling price that would cover the 25% gross profit. But to cover a 25% gross profit, you actually have to increase estimated costs by 33%.
To understand why this is true, look at the four pairs of columns in the chart below. In each pair, the left-hand column represents estimated direct costs of $40,000. The right-hand column in each pair, however, changes depending on what gross profit percentage is being used to figure out the selling price.
Look at the pair of columns labeled 25% Gross Profit. The blue boxes represent 25% of the selling price. But this is 33% of the estimated direct costs. So you have to add 33% of those costs to arrive at a selling price that will cover a gross profit of 25%.
With a smaller gross profit of 20%, you need to add 25% of estimated costs; for 33% you need to add 50% to direct costs. Finally, to earn a gross profit of 50%, you have to sell the job at a 100% markup, or twice your cost.
The magic formula
When it comes time to actually crunch the numbers, there's a foolproof formula for calculating a selling price that covers both overhead and net profit. Simply take the decimal value of your gross profit, subtract it from 1, and divide it into your estimated direct costs.
So say you're aiming for a 25% gross profit:
25% = 0.25
1 - 0.25 = 0.75
Direct costs / 0.75 = Selling Price
Next time you have to quote a price, don't simply add 15% to your estimate. Instead, figure out what your gross profit percentage should be, then use a divisor to figure the selling price. You may not win every bid, but for those jobs you do get, you'll cover your costs and earn a profit as well.
This article was originally published in the JOURNAL OF LIGHT CONSTRUCTION, a sister publication of REMODELING.