This is something EVERY custom home builder must know in order to predict profitability and avoid leaving money on the table when pricing contracts and variations.
One of the biggest challenges we see residential home builders face is how to price their jobs.
Unfortunately, many builders THINK they are pricing their jobs based on a desired margin, whether that be 20%, 25% or 33%.
However, what they are really adding is a markup which results in a margin of 16%, 20% or 25%, respectively.
That is a huge difference between expected profitability and actual profit being applied…
Throw in some cost overruns and onsite delays, and it’s easy to see why these builders end up making little or no net profit on their jobs, leaving them effectively ‘working for a salary’.
That is no way to run a business!
The Trap Builders Fall Into When Pricing A Job
Many builders are unsure how much markup to add to the cost of sales and ask themselves things like:
- Should I add a dollar figure, or should I add a percentage to the cost of sales
- Should I try to undercut my competitors so I can win the job?
- Should I be pricing in line with what the client wants to pay?
But all of those pricing methods will lead to serious problems down the track.
Instead, the model that we recommend residential home builders use is what we call Pricing 4 Profit. Following the Pricing 4 Profit methodology requires you to focus on your net profit per job rather than the gross profit.
But first, let’s clear up some terminology.
Markup Versus Margin and Net Profit
The State of Residential Construction Industry (SORCI) 2023 Report revealed that almost one-third (29.5%) of builders still don’t understand the difference between markup and margin.
These terms are used interchangeably in our industry and get confused even by some very smart people. However, it is important to realise that they are very, very different.
You may like to refresh your understanding of a few key terms about pricing a construction job:
- Markup = Amount of profit as a percentage of your cost of sales
- Margin = Amount of profit as a percentage of the selling price
- Gross Profit = (Revenue - Cost of Sales)
- Net Profit = (Revenue - [Cost of Sales + Fixed Expenses])
For example, if your material and labour costs are $800,000 for a project and
you add a 25 percent markup, that’s $200,000. Meaning $800,000 plus $200,000
gives you a $1 million building contract.
However, the margin on this job is only 20 percent, which we work out by
calculating $200,000 as a percentage of $1 million (e.g., $200,000 divided by $1
million). Therefore, a 25 percent markup equals a 20 percent margin.
Unfortunately, too many builders mistake their margin for their markup, and because they’re not marking up as much as they should be, they are achieving smaller and smaller margins.
The problem gets worse. In the example we just used, the builder may be thinking that they have a 25 percent margin because they added 25 percent to their cost of sales (a markup).
So when they look at their accounts a few months later and see a $200,000 invoice paid by the client, they do a quick mental calculation: 25 percent of $200,000 means I’ve made $50,000 profit.
But since the margin was really only 20 percent, it’s $40,000 in profit. That’s a $10,000 difference, which is massive when you’re working on tiny margins like this. It gets even worse when that invisible $10,000 profit gets spent.
Multiply that with several jobs running at once, and things get out of hand very, very quickly!
The Correct Way To Price A Construction Job
To grow a residential building company safely and securely, you must price your jobs with the net profit in mind.
Successful operators run their building companies by applying a 33.3% markup to new construction in order to generate a double-digit net margin. Building companies focused on large-scale renovations work on even higher margins, typically adding around 55% markup.
How do your numbers stack up to this industry benchmark?
To learn more about the Pricing 4 Profit model, download Professional Builders' Secrets To Increasing Margins.