As a contractor, you bring passion to every project. However, the wheels come off the bus pretty quickly if there aren’t any profits fueling your passion. That’s why diligence is needed when balancing contractor overhead and profit. While keeping what’s left over for yourself after all the bills are paid may seem simple, generating profit is a make-or-break challenge that doesn’t come as naturally as most new contractors assume it will unless they can get a tight grip on actual overhead costs. Let’s talk about how to do your overhead and profit calculations right so you’re operating in the black.
Putting contractor overhead and profit in perspective
Overhead is a constant looming presence when running any business. It refers to the cumulative cost of running a business. While some industries come with low overhead, construction is generally a high-overhead business due to the fact that you’re using two very costly “commodities” as your income-driving sources. One is raw materials. The other is time in the form of labor.
You may already be familiar with the idea of job costing in construction if you’ve ever whipped up an estimate for a client. Job costing simply refers to tracking, assigning, and estimating costs for each project you agree to take on. Job costing adds up labor, materials, equipment, and other forms of overhead. However, there’s a chance you’re doing job costing wrong if you’re not actively performing job costing with your desired profit per project in mind. More on that in a minute!
Direct and indirect costs
When running your construction business, you’ll encounter two specific types of overhead costs. The first type is direct costs. A direct cost is any expense tied to a particular job. For the average job, this might look like raw materials, rental equipment, some temporary work structures at a site, and project-specific permits. These are the typical factors we use when assessing job costs. However, they don’t go far enough to actually cover the true costs of each project while still leaving you with room for profit.
While direct costs vary by project, contractors always have monthly fixed costs running in the background. These are what we call indirect costs or operating expenses. The highest operating expenses are usually office rentals, salaries and benefits for your staff, business insurance, accounting fees, legal fees, and advertising.
While looking at all of the direct costs and indirect costs that make up your overhead can feel daunting, it’s important to remember that the sole purpose of incurring these costs is to generate profit. Profit refers to the amount of money left over after all of your operational costs are subtracted. The way to discover the profit per contract is to subtract all of your operations costs from your contract bid. For instance, you might have a contract worth $30,000 with an overhead of $22,000 when all is said and done. That leaves you with $8,000 in profit at the end of the project.
There’s a common gray area with profit that newer contractors often trip on a little. As a contractor, your profit margin and markup are not interchangeable. You must add a markup beyond your actual costs for labor and materials in order to make a profit on a job. That means inflating prices to build both direct costs and indirect costs into your pricing before adding a profit cushion that goes beyond breaking even.
Contractors need their customers to cover every cost. If you simply bill customers for direct costs tied to their projects instead of building in charges for indirect costs, you’ll be stuck eating the costs of running your business. No contracting business can cover its bills using this strategy.
Typical contractor overhead and profit considerations
A big portion of the costs incurred to run a contracting business falls under labor burdens. Your labor burden can easily account for 50% of total project expenditures. While you may be paying an employee $20 per hour, the actual labor burden when you tally in all labor-adjacent costs is often closer to $30 to $40 per hour.
Your construction overhead and profit strategy is going to look different based on your contracting niche. The truth is that certain types of contractors simply have to carry more overhead than others. Your ambitions for growth will also factor in when creating a profit strategy.
If your goal is to become a one-person machine with a specialty, you may be able to keep profit margins low because you won’t need to carry the costs of lots of equipment, vehicles, or workers. However, you’ll also be limiting your lifetime earning potential. If your goal is to run a large operation, you will carry higher indirect costs as you accumulate a vehicle fleet, equipment, and staff.
Let’s bring this contrast to life by comparing what overhead and profit might look like for an electrical contractor versus a general residential contractor.
Electrical contractor overhead and profit
We’ll start with an electrical contractor serving a 40-mile radius. This contractor has a steady crew of five electricians. Here’s what indirect monthly overhead might look like before direct project costs are factored in:
- Payments, insurance, gas, and maintenance for five vehicles.
- Salary and benefits for five electricians.
- Salary and benefits for an office staff of two.
- Employee taxes.
- Office rent.
- Office supplies.
- Office expenses like utilities.
- Procuring new tools and equipment.
- Legal services.
- Marketing services.
- Advertising costs.
Due to the consistent nature of the work being done, the owner of this business generally has consistent indirect costs to cover every month. However, the small staff does actually increase the overhead percentage in this scenario slightly due to the fact that the owner of the business has fewer employees to spread across projects.
Residential general contractor overhead and profit
Residential general contractors (GCs) carry all of the same overhead burdens that all other contractors carry. However, a general residential contractor has to deal with more wildcards that can drastically reduce the wiggle room between overhead and profit.
The simple reason why is that you’re taking on a wider variety of projects that require different resources. This means that your overhead expenses can vary greatly from month to month. As a result, your profit-generating plan needs to be dynamic enough to adjust from month to month.
The unpredictability of the resources needed for each construction project in GC life is responsible for the inconsistent overhead. While an electrical contractor may know that they need five consistent employees to keep up with demand, a general contractor may go from needing five people at one site to needing 20 at another in the span of a week. As a result, general contractors need to build higher indirect costs into every bid to recruit, retain, manage, and compensate workers and subcontractors.
General contractors also need to have the reserves needed to cover large equipment rentals. In addition, general contractors also need to carry more substantial insurance to cover the wide breadth of projects they take on.
How to calculate overhead and profit margin in construction
It seems simple enough to say that your profit is the money left over after covering all costs associated with running your business. However, contractors really need to roll up their sleeves to create full-on business plans that feature airtight strategies for calculating overhead and profit the same exact way each month. You can’t accurately count profit unless you’re accurately counting overhead. One of the biggest mistakes contractors make is not keeping accurate accounting records for every dollar that goes out.
A good place to start is with a target amount for your profit percentage. The general rule is that 5% profit is low, 10% is average, and 20% is considered excellent. Once you have this figure, you can work backwards from your costs to determine how much you need to charge clients using a markup number.
Let’s say that you’ve landed a contract worth $30,000 that requires $25,000 in total overhead. While you’ll need to make $6,000 on this project to reach a target of 20% profit, the math only leaves you with $5,000 after all costs are covered. This is where your contractor markup comes into play. Markup refers to the amount you charge beyond overhead for the sake of making a profit. In this case, you’ll need to add $1,000 to your bid to hit your intended profit target of 20%.
4 ways to increase profit and reduce overhead
A common trap for contractors is to continually increase markup as a way to guarantee a profit on every project. However, the problem with this is that it can soon backfire because your bids will become uncompetitive. You can’t just rely on markup to keep your business floating. You have to do some internal work to reduce overhead whenever possible as a method for increasing profit. No, this doesn’t mean cutting corners with labor or safety. It does mean getting smarter about how you use your resources.
1. Be smarter with data
Contractors have everything to gain by embracing data. Not being precise with estimates is one of the most common ways that contractors fritter away profits. While coming up short on one project may be something you’re willing to let slide, coming up short on project after project bankrupts a contractor.
The truth is that there was no way around this in the past unless you hired a team of bidding experts to oversee every single line item. How, that was the past. Software has leveled the playing field for ordinary contractors by providing tools for accurately compiling bids and estimates. Here’s the way to let data protect your profits on every single job:
- Break down your estimates into smaller chunks. Price out your jobs in stages. To do this effectively, itemize every single component that goes into completing a job. No item is too small to make the list!
- Next, leverage job-tracking software to accurately capture actual costs for each component of your estimate.
- Use smart and dynamic features built into your bidding software to evaluate the effectiveness of your bids. This will help you learn where you’re underbidding, overbidding, and hitting the sweet spot for profit.
Dynamic technology allows you to build a continual process of improving bid accuracy. One of the biggest factors for boosting profits instead of continually incurring losses is to identify high-risk items that you may need to pad when creating estimates.
The missing link for many contractors is information. While they can see that they are coming up short of their intended profit goals month after month, they can’t figure out why they’re missing the mark. The truth is that they don’t necessarily have time to pour through their books to identify pitfalls. The beauty of using data is that it makes profit holes as clear as day without the need to have a background in finance.
2. Increase your margins
There comes a point when contractors must consider raising prices to remain profitable. Many new contractors enter the market by pricing their services to be competitive as a way to make up for a lack of experience.
However, they often forget to readjust as they gain experience and reputation. As a result, they are charging significantly less than their competitors even though they are taking on roughly the same overhead costs. If you’re struggling to make the books work each month, it may be time to experiment with increasing prices.
This is where having a profit percentage in mind can help. If you’ve never done the equation shared above for figuring out how much to add to each project to hit 20%, it might be time to start baking that extra padding into your bids going forward. If you’re currently making roughly 10% in profit on each job now, consider slowly eking upward toward 15% profit on upcoming jobs.
If you find that you can push forward with this without seeing any major drops in the number of bids getting accepted, consider pushing up to 20%. If you notice a slowdown in business after raising prices, it may be time to drop down your markup to be aligned with a 10% or 15% goal again.
3. Improve labor productivity with scheduling and communication software
What if you’re losing money due to poor labor management? If you’ve worked your own way up through job sites, you already know how much time is lost by the average employee during downtime and transitions. Inaccurate time tracking of hourly workers is costing you money now that the shoe is on the other foot. How big is the problem?
If you’re overseeing a team of 100 workers earning an average of $24 hourly, timecards that are off by an average of 10 minutes per day are costing you $416 in losses daily. It’s not just about accurately tracking every minute spent in the field. Contractors also need insights about how much of their overhead is being occupied by payroll. Being able to track labor hours and dollars spent on each job allows you to create accurate spending expectations when crafting future bids. That means that you can ensure that labor costs are covered by the customer instead of simply taking losses because you can’t tack on surprise costs after the job is accepted.
Another area where contractors often take big hits is mileage reimbursement. Are you currently using a system where employees are manually tracking their own miles? It’s a recipe for inaccuracies. The truth is that it’s hard to have the general discipline needed to accurately track miles. When employees fudge numbers for mileage reimbursement, they generally fudge the numbers in their own favor. That means that you’re paying for miles that were never covered. Automated mileage tracking can easily save your company 20% on mileage reimbursements.
Improving productivity at your construction business is the ultimate hack for increasing profits without raising prices. While you may feel like everyone is “working hard” at your company, the truth is that many workers spend up to 35% of their time on non-productive activities that can include seeking information, fixing mistakes, and redoing work. If you don’t have job costing software in place to track activities, you don’t have a way to measure the value of how time is being spent. Even a well-meaning employee can be losing you money if they’re wasting time using unproductive strategies. Getting a time-usage breakdown may show you that it’s actually more economical to hire a supportive staff member to handle “research” time for workers deployed at job sites.
Of course, simply getting the right people showing up at locations at the right times is half the battle when you’re managing a contracting operation. It’s impossible to do this without the right job scheduling software. In addition to helping you organize labor for jobs, job scheduling software enables you to communicate scheduling expectations across your entire workforce using a single platform. This software goes beyond just performing the duties of a shared calendar. For instance, contractors using Workyard’s job scheduling software can share tasks, checklists, photos, and more to ensure that workers show up to the site ready to get to work using accurate, updated information.
4. Tighten your payroll processes
Payroll gets slippery very quickly. As any contractor knows, payroll isn’t just a matter of paying employees the agreed-upon rate at specific intervals. Payroll is an entire ecosystem. It requires transparency, accountability, and consistency to ensure that you’re not losing money on labor costs.
Transparency is the first factor. Business owners often feel blind to what their crews are doing throughout the day. As a result, they simply handle billable hours using the honor system. The problem with this is that everything from poor memory to time theft can cause you to pay more for labor than you’re actually getting. Upgrading your billing technology can open doors to:
- Real-time views of your crews.
- Overviews of employee schedules.
- Real-time pivots for scheduling changes that allow you to get the right people to the right locations to ensure that projects can continue on time.
The first place to start is with the addition of electronic timecards for accurate time tracking. Electronic timecards save you from hours of manual work each week. They allow you to collect, review, and export timecards with one easy click to ensure accurate, on-time payments for every single person in your work crew.
A tight payroll ecosystem also allows you to schedule more effectively. Contractors can use historical payroll data to see work trends that can be used when scheduling future jobs. This information can also be used to track productivity to allow you to rearrange the how, where, and when of deploying crew members for specific tasks.
One of the biggest shames in the contracting business is that many contractors believe they can’t make good business decisions because “business” isn’t their industry. The truth is that modern software makes it easy to consistently measure your business performance, form insights and observations, and apply those findings to your next project to increase profitability.
With labor being the costliest factor for most projects, this is the area to focus on first if you want to reduce overhead costs to increase profits. Countless contractors in all niches are already using Workyard to do exactly that. They’re paying less per worker even if they’re paying generously simply because they are eliminating the wasteful spending that is simply built into the “paper” system of timecards, mileage tracking, and job site reporting. Workyard makes it easy to identify the areas where you’re underperforming to find hidden profit.