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
Owners have a gross margin they've built their budget around. They lock in on that number and stay focused on it year round. They know if they hit it, their bank account will end up the size they wanted.
Just glance at your income statement. The gross margin is laid out for you so nicely. You have a line item for gross profit (or something along those lines) and you have total sales. Divide the gross profit into the total sales and there you have it: gross margin for the year.
Most accounting packages offer a report that shows income and expense line items as a percentage of sales. It's a very useful way of looking at your financial performance and figuring out where your money is going. It can make for a nice rule of thumb for future budgets.
Furthermore, gross margin is a useful number for comparing performance with other contractors at trade shows and networking events. It doesn't reveal your true income. It doesn't reveal your size. It implies your field efficiency.
We frequently get asked "I gross 22% on my jobs. How does that compare to other contractors?" Gross margin is the natural language of the owner - just like markup is the natural language of the estimator.
One Final Piece of Advice For You Regarding Your Estimator
Tracking and analyzing markup success is one of the primary reasons an estimator should ALMOST NEVER hide markups inside his various cost components. An example will clarify.
It is quite common for estimators to markup materials prices by, say, 10%; subcontractors by, say, 5%; and self performed work by, say 35%. Next, the estimator pulls them together into one number and starts adjusting the final number based on intuition and recent history.
Then the owner walks up and asks how much he is going to make on the job? What's our cost? And the estimator replies, "Hold on. I'm not sure. Let me back that out."
No. No. No. No.
The Golden Rule of job selection:
- Know what the job will cost you to complete.
- Know the price you can get.
- Decide whether you want the project.
Estimators must become disciplined at adding up all the costs first; then applying a standard markup; then adjust in accordance with the competition, backlog, and quality of client.
(If you are keeping score at home, the example used markups of 1.1, 1.05, and 1.35. They were NOT gross margins of 10%, 5%, and 35%. MAKE SURE EVERYONG IN YOUR OFFICE KNOWS THE DIFFERENCE.)
Ron Roberts, The Contractor's Business Coach, teaches contractors how to turn their business into a profit spewing machine. To receive Ron's FREE Contractor Best Practices Newsletter visit www.FilthyRichContractor.com.