When you look at your latest income statement, you probably check the bottom line first; for many electrical contractors, the net profit figure is often a surprise. If it’s a positive number, you breathe a sigh of relief and hope to repeat whatever smart operations decisions produced this result. If it’s negative, you shove the financial statements into the nearest desk drawer and hope for the best.
The profit figure shouldn’t be a surprise; it should be the result of goal setting that focuses on what you keep, instead of how much you sell. In order to set a profitability benchmark, though, you need to understand the basic components of pricing for profit. In this three-part series, we will look at the concepts of markup and margin, break-even and contribution to profit, and finally, your profit philosophy and goals.
The terms “markup” and “margin” are often used interchangeably, but they are not the same thing. Markup is an amount added to your direct costs to reach your selling price. Margin is the amount of gross profit dollars contained in that price that help to cover your overhead for the year. Let’s use a specific example to show the relationship between markup and margin.
You have a small job with a price of $15,000, and your direct cost for labor, materials and other job costs is $10,000. Is your markup 33 percent or 50 percent? You actually have a 33 percent margin in the final price, but you have to mark up the $10,000 cost by 50 percent to get that margin. Below are the formulas for margin and markup.
Notice that the numerator is the same for each formula, but the denominator for margin uses the selling price and the denominator for markup uses direct costs.
Don’t make the common mistake of trying to obtain a certain margin using that percentage as a markup number. For example, you want a 40 percent margin, and you calculate the price using 40 percent as a markup.
You get a nasty surprise—you have just lost 11.4 percent, or $1,596, by using the wrong formula. If you are confused, try thinking of markup as the tool you apply to achieve a particular target margin in your final price. In other words, you get margin by using a markup of your direct costs. Your markup will always be a much higher number than your final margin. So, if you want a 40 percent margin, you will always have to use a much higher markup number to get it into the final price.
Try creating a sample table, such as the one shown above, to help you get used to the relationship between the two concepts.
Let’s do a couple of sample calculations, using the table and direct costs of $10,000.
Q: What price would you use to obtain a 50 percent margin?
A: Multiply direct costs by the cost multiplier ($10,000 x 2.00) and you get $20,000. That gives you a markup of 100 percent and the price includes a 50 percent margin.
Q: What price would you use to obtain a 331/3 percent margin?
A:Multiply direct costs by the cost multiplier—$10,000 x 1.50—and you get $15,000. That gives you a markup of 50 percent, and the price includes a 331/3 percent margin.
If you look closely at the table, you will notice that the cost multiplier is the bridge between margin and markup. For example, you can multiple the cost multiplier of 2.00 times the margin of 50 percent and you will arrive at the markup of 100 percent. The cost multiplier is just the connecting factor.
Because the terms “markup” and “margin” are so similar, it may help to keep this information handy as a reminder of which is which. Of course, no calculation will provide the perfect price, unless you have correctly assigned your cost items to direct cost or overhead categories. Also, profit ties directly to two major operations issues. First, the percentage of your sales revenue that is related to direct cost items indicates how efficiently and accurately your company performs its site work. Second, the level of overhead as a percentage of your sales revenue tells you whether you are carrying a burden that is large enough to support your work or so large that it weighs down the whole operation.
Next month, we’ll look at the concept of break-even analysis and how shaving or slashing prices can affect profitability. EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached via e-mail at email@example.com.