9 Ways to Increase Your Construction Profit Margins
March 6, 2020
Why the Average Profit Margin for the Construction Industry Is So Low
By now it’s a truism that the average profit margin for the construction industry is low. Those in the industry often joke that most construction firm owners won’t retire wealthy at 65. They’ll have to work until they die or are too old to work anymore. Indeed, contractors themselves worry they don’t make enough profit to support their own families and that they'll die broke.
But this truism--and the humor it gives rise to--obscure a deeper truth: construction profit margins aren’t just low, they’re actually eroding. That’s right. You read that correctly. Low margins are actually getting even lower. Margin erosion--a gradual reduction in gross profits over time--has actually been increasing in the construction industry. According to the authors of a 2019 study in the Journal of Building Engineering, which examined over 2700 projects, although gross profit margins were rapidly increasing between 2008 and 2012 from 10% to almost 20%, they began to rapidly decline after 2014 and fell off a cliff three years ago.
After adjusting for overhead, the study revealed that a whopping 44% of all projects suffered losses rather than achieved profit. That means that nearly 1 out of every 2 projects will result in loss. These numbers are staggering.
And no builder is exempt from this dreaded effect. For evidence, witness the collapse of Carillion, one of the largest UK government contractors, due to 1.5 billion in debts caused by “underbidding for contracts that have had low margins since the financial crisis.” Carillion employed over 22 thousand workers, had multiple billion-dollar contracts and were responsible for the renovation of the Tate Modern Museum and British infrastructure projects. Yet none of this fortified Carillion from shrinking margins due to underbidding--a chronic problem caused by poor estimation and increasing competition. According to McKinsey Consulting, which analyzed over 30 large public engineering and construction companies between 2005 and 2015, 85% had margins lower than 10%.
While large contractors suffer from low construction profit margins, it’s actually small GCs and subcontractors who are being harmed the most from margin erosion. We know that approximately 50% of small businesses will fail in their first five years, but did you also know that only 36% of construction small businesses will ever make it to their fifth year?
In fact, according to an index updated annually by Small Business Trends, when it comes to long-term success, the construction industry fared worse than every other sector. Why? The likely culprit is the continued inability to achieve profitability due to ever-shrinking margins.
Indeed, Leo Quinn, CEO of Balfour Beatty, has stated that although 5% of margins are unsustainable for contractors, two-thirds of builders surveyed in Building magazine claimed their margins were lower than 5%. In reality, construction margin benchmarks that hover between 1.5% and 2% are the new normal according to industry experts. Yet if it’s possible, these famously low numbers are still belying just how bad the situation is. Mark Castile, the COO of MACE construction group, goes so far to suggest that if it is “nearly impossible for contractors to achieve margins beyond 2%,” real profit margin averages were as low as .38% in 2018, dropping from 1.7% in the previous year. While not all sectors are equal, residential home builders in the U.S. who have seen their net profits rise are still not even close to enjoying double-digit profits.
So, will the 40% operating margins other industries experience remain forever out of reach for the construction industry? Are small GCs and subcontractors doomed to work tirelessly only to achieve steadily diminishing returns? According to McKinsey, there is some good news to be found. Contractors can still hope to achieve 20 or 30% operating margins, but only if they redesign their operations to focus on profitability rather than utilization. And this is really the heart of the matter. So many builders simply go into business and forget to monitor the numbers that can mean the difference between profitability and bankruptcy. They don’t understand at a practical level how to run their construction business . . . like a business.
In this post, we highlight the most important numbers general contractors and subcontractors should monitor to increase their average profit margins for the construction industry and start running their business like a business. We also show how all of these numbers essential for achieving profitability can be improved by mastering a single activity during preconstruction: developing accurate cost estimates that will win bids without incurring an unacceptable level of risk.
How to Increase the Average Profit Margin for Your Business (and the construction industry)
The fact is only about 20% of construction business owners know the true cost of their business. They make decisions about bidding and completing projects without ever checking to see if the numbers are adding up. How can you correct a problem if you don’t know there is one? For these reasons, contractors need to know, measure, and track important financial metrics. Firms that take time to identify, measure, and track decisions based on financial, operational, historical, and predictive measures are more likely to increase their success.
Let’s begin with the financial metrics. The most important financial numbers to measure and monitor are:
Profit Equity Overhead Sales Job Cost & Estimates
Contracts Receivables Liability Cash Flow
Do you know what your firm’s gross profit margin is? Or its net profit margin? How much is your overhead? What is the true cost of the job you just won? Do you have the cash you need to invest in your business for growth necessary to achieve success? Knowing the important financial numbers above can make or break your business, so we’ll take a deeper look at these numbers to help you know what each number means to your business and why and how you should track it.
1) Profit Margins
When someone asks you if your business is profitable, do you point to sales or general revenue and nod affirmatively. If so, your business could be in trouble. A business's ability to make a profit is fundamental to its success. Yet most builders are unaware that there are multiple profit numbers they should be watching closely: Gross Profit, Operating Profit, Pre-tax Profit, and Net Profit. Profit is generally understood to be the number of cents a company makes for every dollar of sales.
While revenue tells you how much money a company makes overall and markup tells you the amount by which a product cost is increased to arrive at a selling price, profit tells you how much money the company keeps and more importantly how much cash the businesses has on hand that can be further invested into the company. The point is that neither revenue nor markup is profit and evaluating your company's success by either of those metrics is problematic.
While gross profit only takes into consideration the immediate cost of developing products, operating profit factors in how many other business costs, especially operating expenses, went into developing a product--including labor, overhead and research and development. The inclusion of these operating expenses determines operational profit. If your product sells for $100 but it costs $50 to make and you have $20 of additional operating expenses, your operating profit would be calculated at 30% [$100 - ($50+ $20)]. In contrast net profit, which is usually considered a company’s bottom line, is the money you’re left with after you subtract taxes from operating profit (or pre-tax profit if you’ve financed debt) and it’s the most conservative profit metric for evaluating your business.
Know these profit numbers and start tracking them. Once you do, you’ll start to understand where your business stands and can take immediate steps to course-correct if these numbers are tracking poorly.
What’s your business worth? No seriously. Do you know? The fact is 80% of construction firm owners don’t know. Equity is just a fancy word for the net worth of your business. To find out the value of your business, simply subtract the total liabilities of your company from the sum of its total assets [Assets - Liabilities = Equity]. A top priority for every construction business owner must be to grow the value of their company. How can the company complete more work or grow in size if the company’s value doesn’t grow? Knowing the value of your company is also critical for determining your net profit goal. A 25% return on equity is an excellent goal to begin with for most construction business owners. If, for example, your business’s equity is $500,000, your net profit goal would be 25% of that number, or $125,000.
Another critical number, especially if you want to improve your bottom line, is your business's overhead. Overhead is generally defined as all business expenses that are not directly tied to creating a product or service. Why does overhead matter? Simply put, it’s a critical number to know for determining how much to charge for a product or service in order to make a profit. Whether your firm wins 1 bid or zero or operates at a profit or a loss, your firm will have to continue to pay overhead on an ongoing basis. And these expenses--whether labor or operating expenses--directly affect the overall profitability of your business. And the simple truth is that as many as 30% of firm owners have no idea what it costs them each month to keep their business open.
You should know what your total overhead is every month and carefully track it to ensure your operating expenses don’t exceed it. But you should also be tracking your return on annual overhead expenses because those expenses are an investment in your business’s future.
You would be surprised to learn just how many contractors either don’t have sales goals or don’t track them. Knowing your sales volume as well as having sales volume targets are important to help you reach your net profit goals. To determine your sales volume target you need to know your overhead and net profit goals. If your overhead is $400,00 and your net profit goal is $100,000, you’ll need to add them together to determine your gross profit goal of $500,000. Once you have your gross profit goal, you can divide it by your gross profit percentage to identify your sales volume target.
5) Job Costs (and Estimates)
Job costs, more than any other number we’ve discussed so far, have the potential to completely derail the success of a construction firm, especially smaller general contractors and subcontractors who don’t have huge financial buffers to protect them from projects that incur cost overruns and either reduce profit margins or result in a loss. Again, how can contractors hope to ensure profits if their projects keep ballooning, going significantly over budget?
While numerous factors contribute to projects going over budget, such as frequent change orders, the greatest is a failure to develop an accurate cost estimate during preconstruction. A large majority of builders don’t know the accurate labor rates of their field workers. They also don’t know how much their equipment costs annually or even how much to charge on the job. Both of these can contribute to inaccurate estimates for the biggest part of the job.
Furthermore, because of extreme competition, more and more contractors are underbidding--even working at a loss--in order to keep their teams working. This is actually the worst thing you could do. And it can be easily circumvented by developing an accurate cost estimate. In fact, developing an accurate estimate not only saves you money and helps ensure your margins but it can also help you win more bids because an accurate assessment will allow you to bid lower while still maintaining your profit margins.
There are numerous tools and services you can use to increase the accuracy of cost estimates and takeoffs, but the best is to outsource estimating to a construction estimating service, which allows you to leverage cost estimators with decades of experience by seamlessly uploading your plans online. You’ll be able to achieve an accurate estimate for a job within two days without having to keep an estimator on payroll (increasing your overhead) or having to learn complicated software.
The most successful contractors keep abreast of their contracts. They know which contracts they currently have open and which ones are closed. They also know how much those contracts were for and how well they did on each of those jobs in the past and how well they care currently doing. Make sure you’re reviewing these details.
Bid Gross Profit Markup
Bid Gross Profit Markup
Actual Gross Profit
Estimated Final Cost
Estimated Final Gross Profit
Cost to Date
Profit to Date
Amount Earned to Date
Estimated Cost to Complete
It goes without saying that you need to get paid. It’s not fun to chase down customers who aren’t paying what they owe, but you need to knuckle down and make it a priority. Therefore, it’s a good idea to have an accounts receivable aging report that you review and track weekly.
Johnson & Smith
If you recall, the only way to truly know your business’s equity or net worth is to know your liabilities, which include debt. Successful contractors should create a report that details all debts and liabilities.
Cash. Yes, Cash. It seems obvious, but you can’t run a functioning construction business if you don’t know how much cash you have on hand not only to cover your day to day expenses but also to invest long-term in your business. No matter how much revenue a company is bringing in, without proper cash management, a firm can’t survive if it is sending out more cash than it is bringing in. Of all the cash flow numbers you should be aware of, a weekly or monthly cash flow statement is the most important. While income statements reveal sales, expenses, and profits, only a cash flow statement monitors the movement of money over a specific amount of time. Why is this so important? Because it can shed light on whether your company’s cash reserves are growing or slowly eroding over time.
Achieving 30% Net Profit
Ultimately, these 9 numbers are essential for maintaining the financial health of your construction business and if all contractors, especially those that are small, start measuring and tracking these numbers, we’ll witness industry-wide margin erosion begin to slow or stop and the average profit margin for the construction industry to increase.
There are so many questions contractors can start asking to help keep financial health a priority for their businesses. As profit margins erode or disappear altogether it is tempting to give in to the inclination to offer the minimum in terms of plans and specifications--offering nothing more of value than their competitors. Essentially turning your services into a commodity in which you compete not on the strength of your experience, talent, and acumen but solely on price. But this is exactly the wrong approach.
It’s only when you start to go beyond your competitors and offer something of true value --such as high-quality work or a reputation for getting projects completed under budget--that you’ll be able to win more bids while increasing your net profit margin. Do you have plans for increasing your bottom line that will ensure you’ll get more than average competitive markup? Are you meeting at regular intervals with your team to decide together your gross profit and net profit goals? To develop aggressive but realistic goals you’ll need to know your company’s equity, overhead, and operating risks. You’ll need to ask yourself if you truly know the costs of your projects and specifically if you’re developing accurate cost estimates that will reduce overhead, ensure margins, and give you a competitive edge in the bidding marketplace.
Once you’ve answered these questions and determined how much profit you’ll want to make, you’ll be well on your way to realizing the dream of a 30% net profit.