Articles Written by Charles Vander Kooi

Profit

By Charles Vander Kooi

There are 2 concepts about profit that contractors must understand:

First, profit is a payment for risk. The profit should go to those who take the risk of losing their investment and even their personal wealth. It is a reward to those who are willing to take those risks.
Second, profit is a return on investment. If you put your money in a bank or invest in mutual funds or stocks, you can expect interest. (You expect your stocks and mutual funds to increase in value). Profit in a company is the return on the retained earnings and the initial capital that was put into the company.

The combination of these 2 concepts in construction comes together as follows.

In normal economic times a balanced portfolio of money mart accounts, certificates of deposit, mutual funds and stock investments is returning an average of 9% to 11% on investment. However, these types of investment are fairly low risk.

Because construction is a high-risk business, the payment for that risk should be 2 to 3 times more than the lower risk investments. This means that construction companies, as a return on investment and a payment for risk should have a 20% to 30% return on retained earnings and original capital during normal economic times. While profits may be flat in some markets today, these numbers reflect where you should be in the future of your company.

What true profit means to me

Before you can measure your profit, you must know what true profit is and is not. Let me give you some examples of how contractors deceive themselves about the nature of true profit.

Exaggerated profit

Contractors can show an excessively large profit for any or all of the following reasons:

The owner does not take a salary, only draws on profit shown on the balance sheet, or draws a conservative below-market-value salary for themselves.
Family members (usually the wife) works for the company without receiving a salary.
The company offices are in the home and due to IRS rules, nothing is paid by the company as rent.
Old equipment is being used by the company, which has a zero net worth because it has been depreciated. The company is not setting aside expense money for future replacement equipment.

In order to determine a “true” profit, these shortfalls in expenses must be deducted from the existing profit.

Understated profit

Contractors can show an excessively low profit for any or all of the following reasons:

The owner(s) is/are taking a larger-than-market value salary for themselves. They are taking profit out of the company as salary.
They are building a house or remodeling a house and writing off some of the expenses through the company. Or, they are maintaining their, or a relative’s, house by doing the same thing.
They have started another company or profit center in their existing company and they are getting the start-up costs out of profit.
They have made a large contribution or taken an expensive trip (business, of course) and the company has expensed it out.
They made some large purchase of computers or other equipment that has been expensed.

The total of these items, if they exceed a reasonable cost in a given year, must be added back into profit in order to determine a true profit.

What should your markup be?

I suggest that, in order to establish your profit mark-up on a bid, you begin by having a profit range. Establish the lowest profit that you would accept. For example, let’s say the low range is 10% to 15%, and the high range is 25% to 30%.

Then you must consider 4 things about the job, and apply a profit figure between the low and high to each of the 4 as if each item was the only thing you were considering. After you have done that, add up the 4 profit percentages and divide that number by 4. This will give you an average profit percentage for that job based on your considerations.

The 4 profit considerations

Need. That is, how badly do you need the job? The greater the need, the lower the profit percentage should be. But, if you have a lot of work, then the profit percentage should be towards the higher end of the range.
Risk. Risk comes in several different ways. Labor is the biggest item of risk in construction. Therefore, the more labor there is in a job in relationship to material costs, the greater the risk. If you do not feel comfortable with the number of hours you have estimated to do the project, then your estimate becomes a risk. If there are unusual or potentially troublesome conditions on the site, e.g., rock, water, poor accessibility, etc., then the job is a greater risk. The more risky the job, the greater the profit you should seek. If it is a “piece-of-cake” job that anybody can do, then anybody and everybody will want to bid it and, hence, the profit will have to be low. But, if it is very difficult, then very few will be dumb enough to bid it, and those who do had better go high on the profit because of the risk involved.
Size. That is, size in relationship to what you are accustomed to doing and the size of the jobs upon which you have based your strategy. Let’s say that your best size project is $30,000 and along comes a job for $50,000: Go lower on the profit. If the job is only $8,000, go higher on the profit.
Marketplace. This is the one we all like. The question here is, how many people are bidding the job and who are they? Is it “The Good Times”, with lots of work for everyone, or “The Lean Times” when contractors are cutting each other’s throats? The more bidders there are or the tougher the times, the lower the profit you add.

I like this systematic method to determining the markup better than adding 12% profit to a job because ‘Good Morning America’ said there was a 12% chance of rain today, and it sounded like a good profit figure.

Since 1980, Vander Kooi & Associates, Inc. has been helping business owners add more to the bottom line of their company’s financial performance. We accomplish this through seminars, workshops, home study publications, audio/video, software and private consultations. We would be proud to help you with budgeting, estimating, high-performance management, marketing, sales, productivity and field training. For more information, visit www.vanderkooi.com or call (303) 697-6467.