Margin and Markup
Dear Michael and Tracy*,
Margin is not a topic that comes up much when you have dinner out or when you buy new clothes. Do you remember asking your server about their direct costs for eggplant and just how much is that eggplant marked up? My guess is no. But this topic sure does come up when you engage a builder!
Most businesses, when reviewing their financial performance, look at their total margin, their overhead expenses, and their profit all as a percentage of total revenue (sales). Based on the NAHB Cost of Doing Business Study, the top 25% of custom builders average a 19% gross margin, including about 13% in overhead expenses and about a 6% net profit margin. Remodelers (and folks who complete smaller scope projects) require a much higher margin as they have much higher overhead expenses. We would be delighted if we hit this pricing structure.
Our margin is calculated using a formula that is based on the length of the job and the total volume. A project with the same value that is four months long (versus five months) will have a lower margin. A project with the same schedule that has a higher value will have a lower margin. This formula reflects our overhead and carrying costs for different types and lengths of jobs. For example, a $1.5M house with a 10-month build schedule will have a lower margin than a $700K renovation and addition also with a 10-month schedule.
The fee covers both overhead and profit. Overhead includes the usual list of items, from rent to insurance to payroll for people that do not bill their time directly to our projects. These are the expenses that keep our business ticking along.
Markup and margin are often conflated, and we would like to share the difference and relationship between the two. Here are two examples:
18% Margin Example
If we have a $100 project with $82 in direct costs and $18 (18%) in margin (overhead and profit), the markup on the $82 in direct costs to calculate a $18 margin is 0.2195. $82 x 0.2195 = $18.
13% Margin Example
If we have a $100 project with $87 in direct costs and $13 (13%) in margin (overhead and profit), the markup on the $87 in direct costs to calculate a $13 margin is 0.1494. $87 x 0.149 = $13.
Builder Margin Example
If a financially healthy builder has $1,000,000 in annual revenue (sales), they may have $810,000 in direct costs, $130,000 in overhead expenses, and $60,000 in net profit. Direct costs include direct labor and labor burden, trade partner costs, material costs, fees, equipment rental, and the like. Overhead expenses include labor and labor burden not attributed to a specific project (administration and accounting, for example), rent, insurance, vehicle expense, continuing education, marketing, professional fees, and the like.
One of the most damaging situations in building is when a builder is underpriced, not managed well, and is struggling financially (or ultimately fails financially). Profit is not a four-letter word. Financially healthy, stable, and experienced builders are strong partners for your project.
P.S. What is the markup on the hoverboard? Regardless, I am interested!
*Full disclosure: not only have we never worked for Michael J. Fox or Tracy Pollan, we've never actually met them. Indeed, I'm not sure we've ever been in the same city at the same time. They seem like fun people, though, and we would be happy to build a home for them. If any of you are close friends with them, we would be grateful for an introduction!