Understanding overhead and profit are crucial to keeping your company profitable
Construction companies that have a strategic plan with clear goals and targets make 33 percent more profit than those that don’t, according to a study by the Construction Financial Management Association.
While it’s important to stay busy, a construction company’s primary goal should be to make a profit. In 2019, the Builders’ Cost of Doing Business Study showed that profit margins increased, reaching their highest point since 2006.
To show a positive profit margin in your business, you’ll need a firm understanding of your direct and indirect overhead costs. You’ll also need to make adjustments as necessary to achieve your goals.
Every estimate or remodel project includes overhead costs—ongoing expenditures related to running your business. Although these expenses generate no revenue, they amount to a sizable portion of every project, so calculating overhead correctly is essential to earning a profit.
There are two types of overhead costs: direct and indirect.
These charges relate to a specific project and do not include expenses tied to your day-to-day costs of doing business.
Direct overhead costs might include:
Labor costs, including project-specific wages
Raw materials
Equipment
Temporary offices and utilities
Other miscellaneous costs, including site photos, surveying, and cleanup
These are the expenses related to doing business on a day-to-day basis. Typically, you would share these costs proportionally across all projects.
Examples of indirect costs may include:
Employee benefit and perks
Office expenses like office technology, office supplies, rent, utilities, equipment, insurance, accounting/payroll services, and taxes
Traveling from one job site to another
Marketing and advertising costs (like your Angi account)
Profit margin is the amount of money you make on a project after subtracting all of your expenses.
There are three fundamental ways to measure profit margins:
Gross profit margin: Your total revenue minus cost of goods (COGs)
Operating profit margin: This is the revenue you make minus operating expenses and cost of goods
Net profit margin: Revenue minus all expenses, including taxes and interest. Your net profit will depend on how efficiently you run your business when you take both direct and indirect overhead expenses into consideration.
Your direct material costs, direct labor expenses, and overhead combined make up your construction project expenses. To break even, you have to budget at the project level to cover your overhead costs. Budget too much and you can’t compete. Budget for too little overhead and you can see a negative profit margin (loss).
Understanding typical overhead expenses in construction can ensure there is no negative impact on your profit margin. That’s because an increase in overhead will lower your profit margin.
Indirect labor is typically the most significant overhead expense for construction companies. These costs refer to employees who are not involved in projects but are active in the day-to-day running of your business, like an office manager or accountant.
Construction projects have many indirect material costs, such as lubricants, nails, welding supplies, adhesives, and staples. Some of these expenses may be traceable to a specific job, but it is rarely profitable to do so. That’s because the money you’d spend to trace every screw needed for one project would be a waste of time.
Construction businesses also have expected fixed overhead costs that change very little from one job to the next. These costs might include insurance premiums, safety equipment, and licensing fees.
Generally, variable overhead relates to supplies and utilities, like gas and electricity, that can change from one job to the next. For instance, site cleanup is a variable cost for general contractors because it can fluctuate from project to project.
It’s not uncommon for construction companies to calculate overhead and profit a bit differently. Some companies mark up both labor and materials, while others focus their markup on labor only. Some companies consider employee benefits and taxes as direct job costs, while another company may consider these as overhead costs.
Whatever method you use to calculate overhead and profit, it’s vital that you make enough money to cover your expenses and pay yourself out of your overhead, not your profit.
The Construction Services Industry shows a net profit margin (before taxes) of 17.22 percent for the first quarter of 2021. That’s up considerably from the 8.46 percent margin in the last quarter of 2020.
However, a 10 percent profit and 10 percent overhead are standard in the residential construction industry. Using the “10 x 10” rule, your combined gross profit or margin and overhead would be 20 percent.
With volatile pricing and uncertainty in 2021, many companies have increased their markup from 20 percent to 30 percent.
As a contractor, if your overhead rate is 20 percent, you essentially spend 20 percent of your revenue on providing your services.
When calculating your overhead percentage, you’ll want to add up all your monthly fixed costs (or you can add up your annual expenses and divide that number by 12 to get your monthly costs).
This figure is the amount of money you’ll need each month to keep your doors open. However, this figure does not include any contractor direct costs, such as project payroll or materials. That’s because you will only incur these costs when you’re working.
Profit is the amount of money your company makes during any given accounting period. Don’t include overhead costs in gross profit (except if it’s directly tied to a specific project).
In the construction industry, gross profit margins averaged between 17 percent and 19 percent for all of 2018. Suggested margins can reach as much as 42 percent for remodeling, 25 percent for new home construction, and 34 percent for specialty work. Profits vary based on labor expense, materials, location, and several other factors.
Tracking costs ensure better profitability. As a contractor, once you understand how to reduce your overhead and increase profits, you’ll be on your way to growing your business.
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