Profit is the name of the game. Without it there is no tomorrow – business stops. However, many business owners don’t behave in a way that would convince us that this timeless principle is true. When I ask audiences to respond to the question “How many know your net profit goal for the year in dollars?” my average response rate is lower than 10%. If profit is that important, and we’re running businesses in an industry where the variables are high and unknowns lurking around every corner, it stands to reason that profit should be the focus of everything we do – all of our decisions, activities and strategies. Getting things done is not the main goal. Making good profit (and happy customers) is.
When something is important to us it becomes a priority. For entrepreneurs and business owners, getting things done is a priority. Our human DNA is to make things happen, explore new opportunities and see to it that work is completed on time and satisfactorily. It feels really good! Unfortunately, our drive to produce in the short-term can be our undoing in the long-term. We actually compromise our own success when we allow the lifeblood of our business to be subordinated to busyness. What is most important to you? Have you made a conscious effort to look at the financial picture of your business and take personal ownership of its future well-being? That responsibility begins and ends with you. It’s not the CPA’s or book keeper’s responsibility. It’s yours.
What you must do now
To take back ownership of your business and ensure its future success, make sure you have a clear understanding of gross profit as the centerpiece of your financial planning. Most of you know what gross profit is, but in case you need a refresher, gross profit is what’s left after subtracting your direct costs (also known as Cost of Goods Sold) from your selling price. Example:
Selling price of a remodeling project: $150,000 100%
Cost of Goods Sold: -$105,000 60%
Gross Profit: =$70,000 40%
Direct costs include every cost directly attributable to the production of the product or service. The main 4 components of direct costs are 1) labor, 2) sub-contractors, 3) materials, and 4) incidentals (dumpsters, scaffold and equipment rental, portajons etc.). Knowing your target gross profit percentage goal is step #1 in owning your numbers. If you’re not sure how to calculate that target percentage, there are plenty of industry resources available to help. As a general rule of thumb, home builders average between 16% and 25% gross profit (some higher with a good median of 20% minimum), and remodelers between 25% and 40%. These percentages depend, to some degree, on regional economics, project type and customer demographics. One thing that is true of almost all builders I’ve met regardless of those conditions; they struggle with owning this number and charging enough to achieve it! Getting it right is an essential first step to sustained profitability. Until you have your target gross profit percentage locked in it’s next to impossible to set your own course to success. Your company’s well-being will always be at the mercy of poor sales decisions, demanding customers, and seemingly urgent distractions.
Financial success as a function of gross profit percentage
Gross profit as a percentage of sales is not a moving target. Some businesses may have more than one profit center in which case gp% may differ from one division to another. In those cases, it may be a good idea to predict a percentage of revenue for each division (product mix) and calculate an overall average gp%. For most of us, one percentage will work fine. Whatever the case, find your number and stick to it. Once you have it, all future financial planning decisions should revolve around it, including overhead expense (see our last blog “Success Is in the Numbers” for an explanation of overhead as an investment vs an expense), cost of goods sold, revenue, and especially, net profit which is ultimately the most important number of all!
Why gross profit percentage as the focus?
First, your target gross profit percentage done right should reflect the level of excellence your company delivers, which, in turn, should be set at the maximum attainable level for your region. To find out more about average gross profit percentages by region, check out the NAHB’s Cost of Doing Business Study or consider joining an industry peer group where financials are an open book topic. Whatever you decide, know that profit is not accidental. In other words, profit should be planned for in the same way that overhead expense or direct costs are. It all starts with a valid target.
Second, gross profit percentage is the focal point for determining overhead and revenue goals. The GPScorecard link below provides a simple calculation to fill in the financial blanks based on your target gp%. To give it a try:
- Enter your target net profit in dollars in the corresponding space at the bottom of the chart
- Enter your target overhead expense amount in the next space above net profit
- Add Net Profit + Overhead = Gross Profit
- Gross Profit ÷ Gross Profit percentage = Sales REvenue Goal (Note: cost of goods sold percentage is always the reciprocal of the gross profit percentage)
Being a profitable construction company requires being on purpose. If your profitability has been less than consistent or predictable, you can take control today by investing a few minutes a day working on your business and intentionally planning for success. In part III of Success in the Numbers, we’ll review some simple estimating practices to set your jobs up for more profitable outcomes. In the meantime, Legacy Business Leaders is here to answer your most challenging questions in the construction industry. Feel free to call or email anytime. Wishing you the best success this year and beyond!