Once a contractor has come up with his estimate of hard costs to complete the job, he will mark up his costs to determine the bid price. The hard costs – the money paid out for labor and materials — is marked up to cover overhead and profit.
Overhead. Overhead includes all the “soft” costs incurred by being in business that are not associated with a specific job – for example, trucks, tools, and equipment; office expenses, bookkeeping and accounting; advertising, training, legal, insurance, and other costs of being in business. If a contractor does not charge enough to cover his overhead, he won’t be in business long.
Profit. The other component of markup is net profit, often referred to simply as “profit.” Net profit is amount left for the owner after paying all hard and soft costs to complete the job (gross profit net profit plus overhead). If the company owner works part-time of the job, his labor cost while swinging a hammer is treated as a hard cost of that job. If he works in the office and pays himself a salary, his office pay would be counted as overhead. If the job is profitable, the owners would earn profits in addition to any wages paid to them by their company.
CALCULATING OVERHEAD AND PROFIT
Every company calculates overhead and profit a little differently. For example, some companies consider labor burden (employee benefits and taxes) as a direct job cost, some consider it overhead. Some companies mark up materials, labor, and subs. Some just mark up labor. Some assign overhead based on the time it takes to do a job, rather than the cost of the job. Some assign a line-item expense for the contractor’s management fee in lieu of “profit.” Or they may use some combination of these pricing approaches. Whatever method is used, it’s essential for the company’s survival that they make enough money to cover all the company’s costs. The remaining net profit rewards the owner for taking on risk, and also provides money for new equipment, for working capital, and as a hedge against future losses.
Many numbers get kicked around as the “right” amount of overhead and profit. In general, large companies have higher overhead than smaller companies. In some very small companies, where the owner is on the job site every day, the owner is often primarily working for wages, with a modest additional profit if all goes well.
Because everyone calculates the numbers a little differently, these number are slippery and difficult to generalize. A national survey of 54 builder/developers by NAHB (see below) showed an average net profit of about 9% on land-and-house packages. Overhead, marketing, and sales accounted for another 10% (financing is generally considered a direct cost of construction). This is not far from the “10 and 10” sometimes thrown around for 10% overhead and 10% profit. Custom builders typically work on smaller margins of about 15% to 18% for overhead and profit on new homes, while remodeling contractors typically charge higher rates for overhead and profit. When times are tough, some contractors lower their markup (and profit) in order to attract more work with lower prices.
SINGLE-FAMILY HOME: COST BREAKDOWN
|Sales Price Breakdown||Average||% of total|
|Total Sales Price||377,624||100%|
|Source: NAHB 2009 survey of home builders. Avg. house size: 2,716 sq. ft.|
THE MISTAKE OF MARKUP
If a builder wants to make a 20% margin (also called “gross profit) to cover overhead and profit, he has to mark up his hard costs by 25%. This little twist of math manages to confuse many people – and has probably lead to the bankruptcy of more than a few small contractors who thought they could mark up their jobs by 20% for a 20% gross profit. The math, shown below is simple. To achieve a 20% margin (for overhead and profit), you need to mark up your costs by 25% (see box below).
SAMPLE JOB MARKUP
|Job Costs $10,000+ 25% markup: 2,500Total price 12,500|
|Markup ÷ Price = Margin2,500 ÷ 12,500 = 20%|
The chart below shows how much a contractor has to mark up his hard costs in order to make a certain margin. Margin, or gross profit, is used to pay for a company’s overhead and to provide a net profit at the end of the year.
MARKUP VS. MARGIN
|Markup||Margin (Gross Profit)|
|Note: To achieve the margin in the second column, a contractor must mark up its hard costs by the number in the first column.|