Markup 101 for Remodelers
authors Shawn McCadden | March 11, 2020
It’s a shame so few remodelers know and understand how markup and margin work. My experience indicates fewer than 15 percent of remodeling business owners understand this important component of properly pricing a job before it is sold. That means about 85 percent are using what has become known as the WAG method of pricing their jobs: a wild-ass guess.
Don’t Be a Lemming, Figure It Out
Too many remodelers copy the markup other competitive businesses in their marketplace claim to use, rather than determining their own. For lack of a better way to say it, this is stupid. It’s also risky. It’s risky because there’s about a 1 in 10 chance you’ll be copying someone who knows what they’re doing. The risk is compounded because the costs and expenses between two businesses are always different. Again, if you are guessing, you are acting stupidly.
First, Know What to Put in Your Price
When you price a job, there are three major pieces of the pie that make up the total selling price. The first, typically the biggest, is your cost of goods sold, or COGS. Typically your labor, materials and subcontractor costs—things your business actually sells. Think of them as the ingredients.
Total COGS should be the breakeven cost for your business to build a project, or the cost before any gross profit is added. The next biggest piece of the pie will be your overhead. Overhead expenses include things like marketing, office rent and heat, office supplies, office staff payroll, production manager salary and your salary as manager if you are not working in the field.
The third piece of the pie is net profit. Think of net profit as an expense that must be paid. It should not be a surprise in April when your historian does your tax returns. And by thinking of it as an expense to be paid, it becomes part of the price of every job your business sells. Remember, as a business owner, think of your salary as compensation for your day-to-day responsibilities at the business, and your net profit as the compensation the business deserves for taking the risk of offering services. The greater the risk, the greater the profit should be.
It’s 6th Grade Math
Markup is determined as follows. Total anticipated indirect costs (overhead and profit added together) divided by total anticipated costs of goods sold (COGS) for that same period of time (typically one year) equals the markup to apply to your estimated costs. (Indirect costs ÷ COGS = Markup)
Let’s test this to demonstrate the simplicity of determining markup. Let’s assume, using last year’s numbers as your guide, you will use $600,000 of COGS this year. Let’s also assume your overhead for the year, including your salary, will be $200,000. Let’s also assume you deserve $100,000 in net profit for the risk your business takes serving consumers within this risky industry.
Your total indirect cost will then be $300,000 and your total COGS are estimated at $600,000. Using the markup formula above, this business would need to use a 50 percent markup. ($300K ÷ $600K = .5 or 50 percent) To get the price, we put a 1 in front of the calculated markup for a 1.5 markup on COGS.
Proving the Math
Let’s test our math. Imagine this year your business will do just one project, perhaps a whole-house renovation. Assuming the estimated COGS for that project is $600,000, let’s use the markup we calculated to determine the price to also cover your overhead and profit requirements of $300,000. An estimated cost of $600,000 x 1.5 markup = $900,000 selling price.
If you sell that project for $900,000, and you stay within your estimated cost of $600,000, your business will earn $300,000 of gross profit to cover overhead and profit. If you pay the $200,000 of overhead expenses out of the $300,000 of earned gross profit, you will have also successfully earned the planned $100,000 of net profit.
Watch More Than Just Your Markup
Markup determines price. Margin ensures we are making money. For every markup a remodeler could use, there is a correlating margin. Gross profit margin (GPM) is the percentage of money left over after paying for all the COGS out of the selling price. In our example above, there was $300,000 of gross profit left after completing the $900,000 project, which is 1/3 or 33 percent of the selling price.
That demonstrates that a 50 percent markup creates a 33 percent GPM. This means that for every $100,000 of work completed, the business should earn $33,000 of gross profit to cover overhead and profit.
Now that we have explained margin and markup, there is one more area for concern. Even if your business produces work at the planned 33 percent GPM, if your business comes up short on volume, your profit can be compromised.
If you only produce $800,000 of work, you missed your planned goal by $100,000 of revenue. That means you will come up short $33,000 of gross profit to cover your planned overhead and profit. As a result, after paying your overhead first, the business will only earn $67,000 of net profit against the goal of $100,000.
Fortunately, the opposite is true. If you produce an additional $100,000 of revenue over your goal of $900,000, you will have an additional $33K of gross profit, which all drops to your bottom line. Or you could keep doing the WAG! QR
Shawn’s QR webinar on this topic will be Apr. 22 at 1 p.m. EST. To register go to: qualifiedremodeler.com/mccaddenseries.
McCadden is a speaker, business trainer, columnist and award-winning remodeler with more than 35 years of experience. He can be reached at shawnmccadden.com.