NARI Business Tips: From Setup to Operation
authors Doug King | September 16, 2020
There are numerous self-help publications available on how to set up and operate a remodeling company. Having said that, I am often surprised to hear in discussions I have with people in our industry a number of common misconceptions about running a successful remodeling business. So, I’d like to share a few basic tips.
I’ll start with the business entity itself. Of course, please consult with your CPA or tax professional to see what best fits your needs.
There are four classifications for businesses in our industry that are for profit: Sole Proprietorship, a Limited Liability Company, a C-Corporation and an S-Corporation. First, no one in our industry should be set up as a Sole Proprietor because you have zero protection from liability issues created by the business. You can be held personally accountable for the actions and repercussions of your business operations.
I like the S-Corp, which is very similar to a C-Corp in many ways, but it is subject to only one level of taxation, whereas a C-Corp is subject to double taxation. An LLC offers no more or no less exposure to liabilities of the business; it is made up of members, where a C-Corp or S-Corp is made up of shareholders. An LLC is a little easier to set up, which is why it is so popular. Having shareholders, even if it’s just you (the operating owner) allows others to come aboard later as investors. And, when it’s time to sell the company, investors prefer a corporation over an LLC, generally speaking.
One thing to consider before filing to operate as an LLC is that in many states, if a member leaves the company, goes bankrupt or dies, the LLC must be dissolved, and the remaining members are responsible for all remaining legal and financial obligations necessary to terminate the business. These members can still do business, of course: They’ll just have to start a whole new LLC from scratch.
Overhead and Job Costs
Moving past the entity designation, let’s talk a little about overhead. It may be the most misunderstood segment of our costs, and many often overlook these costs when pricing jobs. I think most owners get that rent and mortgage payments, insurance, salaries, utilities, vehicle operating costs, website and cellphones are overhead costs.
There are also two types of overhead costs: variable and fixed. Most of the costs noted above are fixed overhead costs. Variable overhead costs are expenses like fuel, mileage reimbursement, workers’ compensation and liability insurance—things that are not attributable directly to a job and that fluctuate based on your business volume.
Are you aware that whatever you pay yourself should be considered a fixed overhead cost? Conversely, if your salary is tied to your business volume, it would be a variable overhead cost. Your pay should never be considered a portion of your calculated profits.
If you perform labor on a job, then that time you spent performing work is a direct labor cost to that job. The company should pay you for your time, using the rate at which the job would normally pay based on the experience level you would’ve hired. Some of the discussions I have with other remodelers are that the owner who is performing the work brags about the hourly rate at which they paid themself, say $50 to $100 per hour. They then deduct that pay from the profits, thinking they are reducing taxes for the business. What is really occurring is that they are in a death spiral. That model will not last very long because the true job costs are being miscalculated.
Analyzing a Hypothetical Job
Let’s look at a typical job using round numbers, where the owner is using the death-spiral method described above.
- $500 materials
- $2,000 labor, performed by the owner
- 10 percent overhead. The owner pegs overhead at 10 percent of selling price because he or she is making the mistake of not considering the $2,000 pay as part of overhead costs.
- This leads to a false margin, which is calculated as follows:
- $500 materials times a 1.5 markup equals $750 plus $2,000 owner labor “profit” for $2,750 selling price.
The owner thinks the profit is $2,000 + $250 for material markup less ($275) for overhead costs for a total profit of $1,975 or 72 percent margin. (Yes, I’ve heard folks describe it in this manner!) The reality of it is that the profit is calculated as follows: $2,750 selling price minus $500 materials minus $2,000 labor equals a $250 gross profit.
Subtracting the 10 percent overhead of the selling price $275 equals a $25 loss or negative 0.009 percent net profit—hence the death spiral mentioned above.
The point is that whether you choose to count your pay as an overhead cost or a direct expense, it is a cost to the company and must be marked up the same as all costs. Otherwise, you will find yourself out of business in a short period of time.
The following are proper calculations, using the same markup and doubling the overhead costs to 20 percent to cover owner’s pay.
- $2,500 materials/labor times 1.5 markup equals a $3,750 selling price;
- $3,750 minus $2,500 materials/labor leaves $1,250 gross profit;
- Then subtract the 20 percent overhead costs ($750) leaving a net profit of $500 at 13 percent.
This is a heck of a lot better than the 0.009 percent lost, and the company is able to thrive with a fair selling price to the client.
There’s nothing worse than a company thinking they are making a huge profit when in reality they are losing money. QR
Doug King, CR, MBA, is president of the National Association of the Remodeling Industry and owner of King Contracting, Inc., St. Petersburg, Fla.