Don’t Leave Yourself Short: What’s eating away at your profits, part 2

By Matt Firestone | Jun 14, 2024
bill with a bite taken out
In April, I shared the first of three factors, identifying and including costs, that can eat away at your profits if you aren’t careful.

In April, I shared the first of three factors, identifying and including costs, that can eat away at your profits if you aren’t careful. While there is nothing earth-shattering about any of these factors, they somehow still seem to slip by and can make a job go from great to good or good to not so good.

Factor 2: Profit markup and margin

As I travel around teaching estimating courses, I’ve noticed a common misconception among electrical contractors regarding markup and margin. It is not uncommon to hear these terms used interchangeably or even see them as a means to include overhead and profit on the project. This misconception can lead to less profit than intended. 

Markup relates to the costs of a project. Profit markup is the percentage added to the project’s total costs representing the profit we intend to make. For example, typical project costs include material, labor, direct job expenses (DJEs) and overhead. The bid amount is calculated by applying a percentage markup to these costs.

The formula below helps illustrate this.

(Material + Labor + DJEs + Overhead)
× (1 + Profit markup %) = Bid amount

If project costs are $38,200 and you apply a 10% profit markup, the bid amount is $42,020. This calculation is fairly straightforward; but it focuses only on covering costs and a predetermined profit amount.

Margin, however, is a function of revenue or bid price. It measures how much of each dollar earned is profit. Your accountant typically calculates this as part of the net income, comparing net profit to total revenue. However, this principle also applies at the project level, considering the project’s net profit against the total contract amount. The formula for profit margin is shown here.

Net profit ($) / Total revenue ($)
= Profit margin

A project with a $100,000 net profit on $1 million total revenue has a 10% profit margin. However, there is a discrepancy when we examine margin at the bid level using the same numbers from the markup example. Despite expecting a 10% profit (from a 10% markup), the profit margin effectively comes out to 9%.

This difference is because the margin is calculated based on the selling price, not costs. Even a small difference, such as 1%, can become significant with larger markups—a 15% markup equates to about a 13% margin, and a 20% markup results in a 16.7% margin.

The essential difference between these concepts is their base. Markup is applied to costs, adding profit on top, while margin is a function of sales, representing what percentage of revenue is actual profit. This distinction is vital. Treating them the same can lead to setting prices that don’t achieve the desired profit margin.

You may need to rethink how you apply markups to achieve target profit margins. Adding a markup without considering the margin can lower profitability. Adjust your pricing strategy to ensure you cover all costs before profit to secure  your intended margin on every job.

Factor 3: Cash flow

As the saying goes, “Cash is king.” If it is not properly managed, cash flow causes a good project to go bad, and it can be the slow leak that causes the whole ship to sink. Cash flow issues can hurt all businesses. Several factors can come into play regarding cash flow: payment terms, retainage, aging receivables and buying tools and equipment for a project when the current ones will get the job done. 

A simple cash flow model illustrates that throughout a project, we will need 20%–30% of the total contract amount available in cash or cash equivalents. So, for a $200,000 project, you will need $40,000–$60,000 available. Cash flow can eat into your profits when you have to borrow money to finance a project and don’t include the interest in the estimate, or when you use cash coming in from one job to pay for another and end up short and can’t finish the first one. 

A system in place to monitor cash flow pays dividends to help build a healthy bottom line. The cash flow leak is often slow, and it may be too late to fix the problem when the root cause is identified. 

When putting your next bid together, think about the three factors discussed in these articles. Running a business is hard enough. Don’t leave yourself short by not understanding how to manage the profitability of your projects and business. /

About The Author

FIRESTONE, a former contractor, is the owner of Firestone Consulting Group. He can be reached at [email protected].





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