Too many contractors focus too much energy on their top line. Most everyone has heard the old adage, "It's not how much money you make, its how much you keep." In today's construction recession, that statement carries more weight.
The top line is extremely hard to grow. In fact more than 95 percent of all commercial contractors' top lines have had to shrink in order to survive. All the more reason to take a "bottom-up" thought process.
So how much money should you be making? Start by understanding that construction is risky business. It has one of the highest failure rates in the U.S.
Next, understand the concept of risk versus reward. Your reward, or return on investment (ROI) in construction, should be high compared to other industries. Return on investment of 25 to 40 percent is not unreasonable. That should, in fact, be your target and first metric that goes into your algorithm.
A simple way to do this: divide the current book equity number from your balance sheet by your annual net profit (before taxes and any shareholder distributions).
How can construction contractors hit that 25 to 40 percent ROI range year after year no matter the market conditions?
Use this bottom-up approach Excel worksheet to help you do the following steps.
1. Start with ROI
- Go back several years and generate a range of ROI percentages from your statements
- Use the confidential management version of your statements, not the formal statement you show the IRS as it may be adjusted
If your results are not in above 25 percent, be realistic and select a target return on equity that is.
2. Chart of accounts for expenses
- Go through your chart of expenses line by line
- Determine if costs are fixed or variable
Does it stay pretty much the same as your revenue changes? If so, label it as a "fixed" cost. If it moves up and down with revenue, like direct job costs, call it "variable."
3. Start with fixed overhead
Go through each line item and determine if that number is accurate for the coming year or should be adjusted. Salaries quite often make up two-thirds of overhead.
4. Review direct job costs
Once you review direct job costs, i.e., labor, materials, equipment, etc., determine if the percent of revenue each line represents is accurate or can be tweaked (hopefully downward). Subcontractors typically make up most of a general contractors' direct job costs. Tweaking them is harder to do but carries less overall financial risk. Consequently, GCs typically have a lower average ROI than trade or heavy civil contractors.
Trade contractors should pour over the labor number, because it typically offers the greatest risk and the reward. Improving labor productivity (do more work with the same or lower labor cost) can have a ten-fold effect on your bottom line compared to reducing fixed overhead.
5. Add ROI to Adjusted Fixed Overhead
Add the dollars you calculated in Step 1 (desired ROI) to the dollars of adjusted fixed overhead you determined in Step 3 and you have "the nut" that needs to be covered.
6. Divide variable costs percent of revenue from the nut
Divide the percent of revenue you developed on all your variable costs from Step 4 into "the nut" and you back into the sales volume needed to make all this work.
7. Reality check
Is that required sales volume doable?
If it's twice the size of any annual revenue you have ever done, then some adjustments need to be made. You can either improve variable cost percentages (the biggest bang for your buck), reduce fixed costs or lower your target ROI. Try these adjustments in that order.
President of Contractor Score LLC, Glenn Matteson has been advising contractors how to improve their company’s performance since 1985.