Today, we're going to build a bridge over a canyon of misunderstanding. As with virtually all cases of misunderstanding, this one starts with miscommunication.
Guy and I run into the miscommunication frequently. It rarely causes great harm. However, it often leads to innocent errors that cost time and money and make year over year comparisons difficult for growing companies.
It also creates some annoyance to the individuals involved. If you've been involved in one of these little miscommunications, you probably were frustrated. If you were, we feel for you.
The miscommunication involves two very common terms: Gross Margin & Markup.
First, allow me to define them. Then, I will explain why everyone in your company needs to master their use and meaning. Formula time - YEA!
GM = GP / P
MU = P / DC
Well, that should have cleared everything up for you.
What? It didn't? Silly me. I'll carry on.
(Forgive me. My inner engineer is coming out. We think in formulas. It's true. We really are strange.)
Let's translate the formulas into English.
Gross Margin (GM) equals
Gross Profit (GP) divided by Job Price (P)
Gross Margin is the portion of the sale that contributes to your overhead and profit. It is calculated by subtracting the direct field costs from the job price, divide that by the job price, then multiply by 100 to turn it into a percentage.
Markup (MU) equals Job Price (P) divided by Direct Field Cost (DC)
Markup is the multiplier you use against your direct field cost to arrive your job price. Markup is easy to calculate, unless your estimator has buried his costs. More on that sin later.
Why The Miscommunication?
The source lies in the different perspectives of the owner and the estimator.
Estimators are required to think linear and forwards: calculate cost, mark the cost up by some factor, and arrive at the price to offer the customer.
This leads estimators to use a forwards-looking term. In other words, markup.
Owners need to review and evaluate past performance. It's a very important part of their job.
It is the foundation for future business decisions, especially those that involve staffing and investment. When in this mode, they think in terms of the past, which leads them to a backwards looking term. In other words, Gross Margin.
The estimator is running around asking "How much do I need to mark this up?"
The owner is running around asking "How much money did I make?"
Here's The Rub
Most contractors assume the two terms mean roughly the same thing and move in nearly the same magnitude.
They don't mean the same and they certainly don't move the same.
I wouldn't waste time on this little misunderstanding if it wasn't the source of so much frustration and confusion.
Fairly small movements in markup lead to big movements in gross margin.
For example, going from a markup of 1.2 to 1.3 equates to your margin going from 17% to 23%!
That's the first lesson here: the two do not move at the same rate.
Wondering whether there is a formula for translating the two? There is.
You can calculate the gross margin from the markup by: GM = 100 x (MU - 1) / MU
You can calculate the markup from the gross margin by: MU = 1 / (1 - GM/100)
Now I challenge you. No calculators allowed. You don't actually carry one on your belt do you?
You want a 27% gross margin on the upcoming job. What markup should you use?
Hmmm. Let's see. That's 1 divided by 1 minus .27. So, that's 1 over .73.
Even I can't do that one in the head easily - and I'm really good with numbers. Your calculator will reveal that your markup needs to be 1.37.
Do you see why estimators and owners struggle with the transition from gross margin to markup and back?
That's lesson number two: the mathematical gymnastics are beyond the normal person's ability to do it in his head. Again, leading to great misunderstanding.
Estimators, take a seat. Time to expand on the owner's perspective