Eroding profits

Jim is proud of his roofing business! He founded it several years ago and has a large team of installers and labourers on his payroll.  Jim deals primarily with commercial businesses and considers himself a savvy business owner.  He negotiates his contracts using a pricing tool that he believes will yield a 30% margin on his direct costs.   He first develops a detailed cost estimate for each project and his extensive experience allows him to develop a very good sense of all the relevant costs which are put into his tool – he includes labour plus benefits, vehicle costs, fuel, depreciation, travel time, materials, etc.  Once done, Jim then adds 30% to all the costs he expects to incur.

This year Jim took an accounting course – he decided to increase his financial literacy and it was the first time that he started to review his financial statements.  In the past, he felt he had always made “enough” money, but Jim was five years away from retirement and realized he hadn’t put aside enough money. He saw the need to present a “healthy” outlook for his business to a prospective buyer in case he decided to sell the business in a few years.   Much to his surprise, Jim quickly learned that his margins were only 20% and that his overhead costs had gradually crept up – he was making a profit, but his recent years of performance were lacklustre compared to the good old days.  Do you relate?

Make no mistake mark-ups and margins are not the same thing

Through his accounting course, Jim quickly realized where he had gone wrong. He thought that mark-ups and margins were the same thing, i.e., if he marked a job up 30%, he would earn a 30% margin. But, mark-ups are the amount added to a cost to price a good or service to cover overhead and profit, and margins are the profit that is made after direct costs are subtracted from margins. To better understand the relationship between mark-ups and margins, Jim went back to an old job where costs were estimated at $10,000, meaning his mark-up of 30% made his quotation price $13,000 ($10,000 x 30% plus the original cost of $10,000).  BUT this did not result in the thirty percent margin he had expected.  The margin would have been 23%.  Jim found that with a quote price of $13,000 and estimated costs of $10,000, the gross profit would be $3,000 which is 23% of the quotation price.  If Jim wanted to earn margin of 30% on this past job, he needed to mark-up his costs by 43%.

Then, while reviewing this job, Jim realized he hadn’t even made that 23% margin. This is because costs crept over what he had projected and ended up being $12,000. This meant that Jim only made $1,000 of the $13,000 he charged to the customer, which is a margin just below 8%. Not much is it? A margin so minimal meant Jim was barely able to break even on this past job, a job he thought he was making an impressive profit on.

As a result, his margins were lower than expected and this coupled with creeping overhead costs significantly diminished his profit results.  Jim learned that he needed to get better at estimating, learn what his “break even” threshold was and create a budget to manage and control overhead creep.

Test you pricing tool – are your mark-ups high enough?