Most projects are priced by a contractor creating an estimate of the expected ‘direct costs’ of the work – labor, materials, subcontractors, and other fees like permits, dump fees, etc – then multiplying the direct costs by a markup factor.

Seems pretty simple. Doesn’t it? 

If only 🙂

The reality is that pricing, markup, margin, and profit are not very well understood by a vast majority of contractors, let alone their clients.

In this post I will address 3 common misconceptions:

1. There is no standard contractor markup
2. Markup and margin are not the same thing
3. Markup is not what the contractor keeps as profit

Before I do, let’s get the definitions sorted out

Direct Costs

These are the costs directly tied to building a specific project. These costs include labor, materials, subcontractors, fees, rental equipment, and so forth.

Overhead

This is the cost of doing business. Costs that are spread out over all of the projects the contractor builds. Office expenses, Owner salary, administration, insurance, rent, advertising, warranties, etc. 

Different contractors may assign direct costs and overhead in their own way. There is no standard. One contractor may purchase a GL (general liability) policy on a job by job basis and therefore it’s a direct cost, another buys one policy and spreads it out over all projects in a given year.

Some contractors may account for project management as a direct cost while others assign it to overhead.

There are no hard and fast rules for how these costs are assigned.

Services

Contractors provide a set of services depending on the type of work they do and projects they build. Some provide design as part of their offerings, others don’t. Some have a niche, others do a bit of everything. Some do cost plus projects, others do fixed price contracts. All of these factors affect the amount of overhead they’ll have.

Which brings me back to the question of standard markup.

No Standard Markup

It would be absurd to think that Mercedes and Hyundai, Four Seasons and Motel 6, or Neiman Marcus and Walmart use the same markup. They are in the same business classification, aren’t they? Cars, Hotels, Retail. On the surface, perhaps they are, but in reality they deliver something very different from one another.

The built in overhead to deliver a certain experience or set of services varies by the complexity involved and skill required to deliver it.

The same goes for Contractors!

Markup and Margin are not the same

This was an epiphany when I learned it back in the day as a young guy just learning about business. I thought a 20% markup meant we made a 20% profit.

Au contraire!

For example:I have a widget that cost me $100 to make and I sell it to you for $200. The markup is 100%. The (gross) margin is 50%. 

Cost ($100) x Markup (100%=$100)=Price ($200)

Price ($200) – Cost ($100) = Margin ($100) which is 50% of the price.

Therefore, a 100% markup results in 50% (gross) margin

A hypothetical Kitchen Remodel with a cost (direct costs of labor, materials, subs, other) is $100,000 with a 40% markup applied.

Cost ($100,000) x Markup (40%=$40,000)=Price ($140,000)

Price ($140,000) – Cost ($100,000) = Margin ($40,000) which is 28.57% of the price

Therefore, a 40% markup results in a 28.57% (gross margin)

How about a new home?

Cost ($1,000,000) x Markup (20%=$200,000)=Price ($1,200,000)

Price ($1,200,000) – Cost ($1,000,000) = Margin ($200,000) which is 16.67% of the price

Therefore, a 20% markup results in a 16.67% (gross margin)

Markup is not what the Contractor keeps

Out of the gross margin comes the overhead. 

Using the hypothetical Kitchen remodel from above. If there’s $40,000 left after paying for the direct costs, that’s what’s left to pay for the cost of doing business. What’s left after that is net profit. 

Gross profit (margin) – Overhead (expenses) = Net profit

Businesses need to make a profit

A business needs to make a profit to be viable and to serve its customers. Most small businesses barely make a profit at all. A worthy target for a contractor is 10% net profit, but even 5% for a disciplined business is workable. Sadly, most contractors don’t know simple accounting and are just making it up, or using some mythical ‘standard markup’ that they heard is the ‘industry standard’. 

An unprofitable contractor could cost you twice!

Working with a contractor who doesn’t understand accounting and how to calculate a markup for their business could lead to disaster (you know the saying, robbing Peter to pay Paul?). When a contractor gets in hot water they use money from new jobs to cover past expenses. It’s a game that’s not sustainable and, unfortunately, unwary homeowners get left holding the bag. If that contractor goes out of business or skips town halfway through the job, a homeowner is still on the hook to pay vendors who haven’t been paid. Their home can be liened and they can end up paying twice (or more) to pay bills they thought were already paid and hire a new contractor to finish the job.

I hope this helps you understand how contractor pricing works. You need to ask the right questions going in to be confident that your contractor is running a financially sound business. It’s definitely in your best interest to do so!

If you have any questions about contractor pricing, please comment below!