Construction Markup vs Profit Margin: Calculating Each — and Choosing the Right Method

While speaking with contractors, one of the most common accounting mistakes estimating professionals see is the terms "markup" and "profit margin" being used interchangeably. This could be leaving many contractors and general contractors with far less profit on the books each year than they're expecting. Let's take a look at the difference between profit margin and markup and how to calculate each to pick the preferable method. By grasping the difference between these terms, contractors can bolster their bidding process, improve profit and reduce risk.

The Difference Between 'Margin' & 'Markup'

The root of this particular profit problem is the mix-up of terms “margin” and “markup” and using them interchangeably to mean gross margin.

While profit margin and markup both help set prices and measure productivity, they reflect profit differently. And with a keen eye always on the bottom line, it’s critical to appreciate the difference between profit margin and markups. Here are some terms to keep in mind:

Job costs capture everything needed to do the work, including labor, materials, leased equipment costs, projected capital costs (if borrowing money for the job), bonding premiums, permits, and fuel, and other direct costs. Some businesses refer to this as Cost of Goods Sold (COGS) or direct costs, which include the expenses that go into making your products and providing your services, excluding overhead expenses. Calculating COGS could include materials and direct labor costs.

Overhead includes the bills, office equipment and expenses not included in job costs to the run the construction business or administrative expenses. It may include items such as office rent, office support staff, types of insurance, equipment, tools, accounting, bookkeeping, legal fees, owner’s salaries, and outstanding debt payments all operating expenses required to run the business.

Revenue is the income earned by selling products and services. Revenue is the top line of an income statement and reflects earnings before deducting costs.

Net profit is what remains after job costs and overhead are subtracted from the total cost. Net profit can be used toward capital investments (i.e., additional office, new equipment or machinery). Experts say a rule of thumb that a business is healthy should be able to count on a net profit of at least 8 percent.

Gross profit is the revenue left over after paying the expenses of making your products and providing your services. Gross profit is revenue minus COGS.

Markup is the difference between the cost of materials or services and the sales price charged for them. The figure is always based on the cost of the job. In brief, markup is the sales price minus the job costs. Markup shows how much more a contractor's selling price is than the amount the sale cost them.

Markup percentage is the percentage difference between the actual cost and the selling price.

Margin, or more accurately a gross margin, is the gross profit on a job and is a percentage of the sales price. It shows the revenue earned after paying the COGS as a percentage of the gross profit. While a markup is always based on job costs, a margin is always based on sales. Think of it as margin is the sales price minus the job costs and minus overhead allocation.

Gross margin percentage is the percentage difference between the sales price and the profit.

Unfortunately, calculating profitability is not as simple as believing that a markup of 20% on a project will result in a 20% gross margin on the income statement. It’s time to keenly focus on the crux of the issue: knowing the difference between the margin and markup — and choosing a preferable method.

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Respecting Perspectives: Estimator vs. Owner

To choose the right method for a given project, it's important to respect the difference in perspectives between the owner and the estimator. Without that appreciation, miscommunication and misunderstanding of all those terms can persist.

Estimators are typically required to calculate cost, add on to that cost by some factor to make money, and arrive at the price to bid. This way of thinking leads estimators to often use the markup method – in that “add on” step.

Owners need to review and evaluate past performance to make sound future business decisions, especially those that involve staffing and investment. Thinking in this way, gross margin is the method of choice. Owners have a gross margin they've built their budget and focus on it year-round. It’s their goal to hit, and how they’ll measure business success and profitability.

The varying perspectives have these pros asking different questions. The estimator is looking ahead asking "How much markup should I do?" while the owner is looking back and asking, "How much money did we make?" These questions will not provide the same answer. Fairly small adjustments in markup lead to big changes in gross margin. For example, increasing markup from 1.2 to 1.3 equates to the margin going from 17 percent to 23 percent.

The miscommunication stems from that difference of perspectives. Gross margin is the natural language of the owner, whereas markup is the natural language of the estimator. Yet, everyone needs to be thinking of optimal profitability — and for that, the margin method tends to be the best bet.

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How to Calculate Markup & Margin

Yes, it’s true that contractors can use markups to make a profit on a job, but without proper calculations, they may fall short of their margin goal and leave money behind.

Similarly, the wrong calculations are possible when contractors use gross margin incorrectly. This can lead to erroneous estimates, incorrect sales price and lost profit.

Let's recap some key terms and review some calculation examples to improve profitability and project success.

Markup is the multiplier to use against the direct field cost to arrive a job price. Markup is easy to calculate, unless the estimator has buried their costs (never recommended if you expect to know true profitability).

The calculation is: MU = P / DC

Markup (MU) equals Job Price (P) divided by Direct Field Cost (DC)

Gross Margin is the portion of sale contributing to overhead and profit. Calculate it by subtracting the direct field costs from the job price, divide that by the job price, then multiply by 100 to identify as a percentage.

The calculation is: GM = GP / P

Gross Margin (GM) equals Gross Profit (GP) divided by Job Price (P)

Keep in mind: There’s a big difference between thinking there's 20 percent net profit on a job when in reality it’s closer to 12 percent or even lower. It’s important that owners know their overhead costs and use that knowledge to set bid amounts accordingly. When margin is too thin, then the company is vulnerable to unanticipated issues with materials, equipment, weather delays, and a collection of problems that occur on any given job.

There is also a formula for translating the two.

You can calculate the gross margin from the markup using: GM = 100 x (MU - 1) / MU

You can calculate the markup from the gross margin using: MU = 1 / (1 - GM/100)

As an example: What percentage of gross margin is ideal? Subtract that number from one. Then, divide the estimated job costs by that figure.

For example, if a margin 35 percent is ideal, then subtract .35 from one, resulting in .65. Then, divide the estimated job costs by .65. That will result in the amount needed to reach a sale price with the correct gross margin: $6,500 / .65 = $10,000.

Let’s consider this in another construction business scenario. Say a business' total forecasted sales for the year are $1 million and the annual expected overhead costs at that level are $80,000. That’s an 8 percent cost of overhead — they'd need to add more than 8 percent to the cost of the job to simply break even.

Some owners who take this close look may see they’re overspending on overhead or are not setting aside enough to cover office rental costs. These insights may obviously drive business decisions that improve the bottom line.

Take another example: A contractor is bidding on a job that will cost $200,000 to complete with materials, labor, and equipment. They plan to bid $250,000. At 8 percent, their overhead allocation for this job would be $20,000.

A good (accurate and profitable) bid is not about adding on a standard percentage to job costs. Contractors must be precise about their business’s financial needs and as exact as they can be about their costs and revenue goals.

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