By now, we’re all aware of how our rollercoaster economy has impacted construction companies across the nation. In response, many builders and remodelers are considering using cost-plus pricing to reduce their risk. While many things factor into crafting and executing a time and materials contract, the first thing to focus on is calculating the correct markup.
Let’s break this down into three simple steps to ensure that your company stays profitable:
- Calculate the absolute minimum you need to charge so you don't lose money
- Find your "sweet spot" for turning a profit
- Review and update your mark-up, at least once per year
Why choosing the correct markup is imperative to a successful cost-plus pricing model
When you move forward with a cost-plus pricing model, also known as “open book pricing” or a “time and materials contract,” you get paid for the cost of the materials and labor on your site plus whatever markup you have defined. This helps protect your bottom line against things like a shifty economy, because increases in costs are passed along to your customer. In this pricing structure, your profit will mostly be determined by your markup, so while many things factor into crafting and executing this type of pricing model, the first thing to focus on is calculating the correct markup.
But where do you start? First things first, we need to make sure we aren’t going to lose money, so let’s start with calculating the bare minimum markup.
Calculate the absolute minimum you need to charge
You’re running a business, not a charity, which means you need to make money to keep your crew employed and your business open. When you decide to use an open book pricing model, the goal is to not only break even, but to become more profitable. Like anything worthwhile, the latter takes time; so, while you put in the work to increase your profit margins, determine the absolute minimum you need to charge to not lose money.
At this point, you’re probably asking questions like “How do I know what my bare minimum markup is?” and “What does it take to break even?” The short of it: You need to charge enough to at least cover your operating expenses, which will get you to break even and remain flat.
Here’s how to calculate your breakeven markup:
Simple as that, right? But how do you find out what those variables are? Here are the three steps you need to take to calculate these key figures:
- Step 1: Forecast your annual operating expenses. Your operating expenses include all the costs you incur throughout the year that aren’t related to a job—things like rent, marketing, liability insurance, and paying your employees. Build your forecast by expense category and by month. While there are a lot of tools to help you do this, you can also just use a simple spreadsheet. Start with last year’s numbers and make adjustments based on how you think next year will be different.
- Step 2: Forecast how many jobs you think you’ll do this year and their average cost before any applied markup. This is the hard part because you essentially need to predict the future. Start with last year’s numbers and then adjust from there based on how you think next year will shake out. It’s not going to be perfect, but it gives you a foundation to start from.
- Step 3: Calculate your breakeven markup percentage. Divide your total annual operating expenses from Step 1 by the sum total of all your expected job costs from Step 2. The resulting number is how much of your overhead (on average) you’ll need to recover from each job just to break even.
Remember: This is just the minimum you need to charge to avoid losing money for the year. You need to adjust up from there if you want to actually make money. Good builders are getting at least an additional 5% points on top of their bare minimum markup, great builders are getting at least an additional 10% points, and the best builders might get an additional 15% or more after covering all operating expenses.
Next, let's talk about becoming more profitable using the cost-plus pricing model.
Calculate markups to find your “sweet spot” for turning a profit using open book pricing
The primary factor limiting the amount you can charge is your competition. If the builder down the street has a 15% markup, it’s going to make it harder for you to get 23%. But don’t let that stop you from trying. After all, you know your numbers, and the builder down the street doesn’t and they will be out of business soon.
So how do you pick a target? There are two approaches to calculate a markup target:
- Start high and work your way down. This may be a good strategy for established builders who already have plenty of work lined up. You can start high (try 20% above your breakeven markup) and drop the percentage until you gain traction and people start signing proposals. Whatever you do, do not “buy a job” by going below the breakeven markup. You’re better than that.
- Start low and work your way up. This may be a good strategy for newer builders trying to establish themselves and build a reputation. You can start low (no less than 5% above your breakeven markup) and increase the markup until people stop signing construction contracts.
Review and update your mark-up, at least once per year
As your business grows and the competition around you changes, so will your mark-up. A mark-up is not something you set at the beginning of your company and never adjust again--the best builders are constantly analyzing their profit margins. At a minimum, this needs to be done once per year. There are two things we suggest doing regularly to optimize your mark-up:
- Recalculate the breakeven mark-up %. In step one, we covered how to calculate the bare minimum markup: annual operating expenses divided by annual expected job costs. Both of these numbers are constantly changing, and therefore so will your bare minimum markup. For example, you might find that as you grow, your bare minimum mark-up will actually decrease...and this is a good thing. The reason for this? Let’s say in year 1 you have one project manager who can handle 2 jobs at a time, but you were only able to win 1 job. After you crush that initial job and you start to win more, you’re now able to have your project manager work on 2 jobs. Now, you have the same operating expenses, but double the job costs. This is great news, because it means you can cut your mark-up in half and still break even. We’ll cover this math in-depth in our e-book, so make sure to subscribe below for future updates.
- Stay on top of the competition. As with any business, you need to know what your competition is charging. There are two practical ways to stay on top of this. First, talk to your customers. Every time you bid on a project, this is your chance to gain competitive intel. Keep track of what you bid and whether you won or lost, and ask prospects what the competition offered. In addition to asking customers, you can also ask your competitors. Join a local builders association such as the HBA and network with your peers. If you’re sensitive about sharing information with someone in your local market, join a Builder 20 group, or create your own by reaching out to other builders on LinkedIn.
Automate Your construction accounting processes and get your bookkeeping in order
Finally, like with many things in the construction business world, heavy math is involved in finding your breakeven percentage and target markup for profit. Not every builder is math-savvy or confident with their calculations, and that’s fine. That’s why technology—and human help—exists.
Simple tech, like spreadsheets, are designed to do complex (and simple) equations for you. Other construction-centric software tools, like Adaptive, automate your accounting workflows and provide you with the reporting you need to find that breakeven percentage and profitable markup target. Find out more about Adaptive and book a demo.
If you’re looking for a partner to help you design your systems and keep them updated, find a trusted advisor to help get your numbers in order and do the math for you! Monthend provides bookkeeping, accounting, tax, and finance consulting services for construction businesses that want to leverage accounting and technology to become more profitable. Schedule a free consult call with Monthend today!