The one question builders ask me more than any other is what markup to use to price their jobs. My answer is quite simple: It depends. There is no magical markup that can be used by all custom builders. Each builder needs to evaluate his own situation to establish the markup percentage he needs to cover operating expenses and make a reasonable profit.
This step-by-step guide will help you identify the target markup that’s right for your company:
1. Establish a Target Profit. First, determine how much profit you would like to make. This amount should be after paying yourself a reasonable salary for the work that you perform for the company. Suppose you anticipate building (and selling) five houses this year, at an average sale price of $800,000. Your anticipated annual sales would be $4 million. For the purpose of this column, let’s suppose you would like to make a net profit of $150,000 this year. This return is in addition to your annual salary, which is not profit but is an operating expense.
2. Identify Overhead Expenses. Go through your chart of accounts and establish a budget for each of your detailed operating expense items. Overhead includes things like salaries (yours as well as those of employees), office rent, office supplies, phones, vehicles, etc. We’ll suppose that your annual budget is $450,000.
3. Compute Projected Gross Profit. Your gross profit must cover your entire overhead and your net profit. Using our example, to cover overhead and provide a projected net profit, you need a gross profit of $600,000 ($150,000 net profit, plus $450,000 in overhead expenses). This equates to a targeted gross profit of 15% ($600,000/$4,000,000 = .15).
4. Calculate Markup. In order to determine the markup you need, first compute your targeted costs of sales by subtracting your targeted gross profit from your total revenue estimate ($4,000,000 sales volume – $600,000 targeted gross profit = $3,400,000 targeted cost of sales.) To determine your markup, divide sales volume by cost of sales. In this example, the targeted markup would be 1.17 ($4,000,000/$3,400,000).
This exercise will provide you with a target that is a good start, but it is important to challenge your assumptions in order to maximize your net profit and at the same time minimize your risk. Ask yourself this question: Can I achieve the same gross profit by doing less work? In order to do this you will need a higher markup.
Using the above scenario, to achieve the same $600,000 of gross profit dollars with four homes at an average sales price of $800,000 you would need to have a markup of 1.23 ($3,200,000/2.600,000), which would provide a gross profit of 18.75%. If you build three homes with an average sales price of $800,000, you would need a markup of 1.33 ($2,400,000/$1,800,000), which would provide a gross profit of 25%.
Fixed-price or cost-plus contracts. With a fixed-price or lump sum contract, you are taking on the risk of being able to bring in the job at or below your estimate. If you go over budget, your profit on the job will be reduced. When determining your markup you need to factor in this added risk over a cost-plus job.
Your goal in a fixed-price job is to develop systems that minimize your risk. The best way to minimize risk is to have a tight set of plans and specs prior to finalizing your contract price. Subcontract agreements and purchase orders will also minimize your risk. Regular review of job cost reports and purchase order variances will enable you to identify and fix problems early so you can hold on to the margins you used in your bid.
