It is surprising but true that a lot of contractors and business owners don’t know how to go about pricing their work. Finding the correct price is a challenge, and many contractors have resorted to “guesstimations” and ballpark figures. Most contractors today just quote a figure that is reasonably lower than their competition, making a grave mistake.
Such contractors bid such a low amount that it makes the business landscape unreasonable for other businesses in the area. They also fail to take all of their costs, expenses, and overheads into account. To figure out the markup a general contractor should take from subcontractors, you first need to understand and appreciate the exact differences between profits and markups.
Difference Between Markup and Profit Margin
According to Investopedia, the profit margin is the difference between the revenue of a firm and the costs incurred by the firm. The total amount of profit is calculated and expressed in the form of a percentage of the total selling price. The profit margin does not take into account any overheads at all.
On the other hand, a markup is the percentage of money that a firm increases its selling price by so as to cover all overhead expenses and costs involved in the production of the service. For a contractor, a markup is an important calculation that lets them figure out the exact markup they need to keep things running sustainably.
Understanding the Theory With the Help of an Example
Since this is a rather ‘math-y’ affair, the best course of action is to tackle it with the help of an example. Consider a contracting job that will cost you $1000 to finish. This is the direct job cost of the project, which you can also consider as the cost price.
Cost Price: $1000
Selling Price: $1400
What are the profit margin and markup over here? The markup is calculated by dividing the difference between the two prices by the cost price. To calculate the profit margin divide the difference between the two prices by the selling price. In other words, the profit margin is 28.57% and the markup is 40%.
How to Calculate the Right Profit Margin and Markup
As you can see, the profit margin is significantly lower than the markup. It doesn’t consider all of your additional overheads. But, if you want to do that, you have to decide on a target profit margin and then quote a markup. This is the best method for figuring out the numbers.
A handy formula is the Margin Conversion Rate or MCR. Consider that your target profit margin is 40%, which can be expressed as 0.40. The MCR is the difference between 1 and this target. In this case, the MCR for your calculation is 0.60. Now, simply divide the job costs by the MCR to find your selling price.
MCR: 0.60
Selling Price: $1000/0.60 = approximately $1667
So, calculating the profit margin for this selling price is 40%, while the markup is 66.67%. If you want to make a profit margin of 40% that covers all your overheads and expenses, then you need to mark up the cost by approximately 67% and charge $1667 in total.
How to Figure Out the Overhead
It is also very important to calculate the overheads involved, especially when you work with a number of subcontractors. Your staff might just consist only of planners and project managers. Even so, calculating the overhead is a very important step of the process and will help you to figure out the right profit margin.
Step 1: Calculate the Overhead
Overhead is basically the sum total of all the fixed costs that you have to incur, even if your firm does not participate in a single project all year round. You have to take into account warehouse expenses, rent, office supplies, advertising, insurance, accounting, etc. Don’t forget to take into account the salary of you and other permanent employees.
Step 2: Calculate the Break-Even Point
The break-even point is where the money you make by working on projects is exactly equal to the costs that you incur while working on them. The break-even point is the threshold that you can use to figure out what the markup, the overhead margins, etc. need to be.
Step 3: Figure Out Your Overhead Margins
The overhead margin is the ratio of the total overhead expenses and the total revenue in a year. You can also calculate this amount by quarter or month – whichever suits your company’s needs. The overhead margin will differ depending on the total number of estimated projects that you will receive in a period.
To understand the exact markup and margin that you should go for, you need to resort to a trick known as a break-even analysis. Basically, a break-even analysis allows you to figure out what the target profit margin should be for a given volume of sales in a period. A high volume of projects means a lower markup rate and vice versa.
Step 4: Figure Out a Target Profit Amount
Next, you have to think of the profit amount that you would like to have. Usually, contractors should choose a profit margin that is 20% of their annual overhead expenses. Plug in this target so that you can figure out the profit margin. Use the MCR and figure out the exact markup.
Figuring out the markup
To sum up, you need to calculate the overhead expenses that you will incur in a time period. Next, you need to calculate the break-even point for your business. By using break-even analysis and predicting sales volumes, you can figure out the break-even margin. Finally, plug in the target profit into your selling price. This is all you need to do to figure out the markup.
Final Thoughts
The Margin Conversion Rate is a useful tool that you can use for all kinds of markup calculations. Using these tools will help you to make informed decisions while setting a price – which will ensure the long-term and sustainable growth of your business in the competitive environment.
