The primary aim of starting a construction business is to make a profit. Pretty straightforward, right?
For new construction companies, this typically means bidding on projects, executing them well, and then earning a profit after all your expenses have been paid.
And if you can do this consistently over the fiscal year, you might even be able to grow your business in a few years, right?
Well, no, not really. It’s simply not that easy. And the numbers are there to show that it isn’t.
According to the Small Business Administration (SBA), about 20% of new construction companies fail in the first year of operation. Within the next five years, that figure rises to roughly 50%. In the five years after that, 2 in 3 (66%) startup construction companies fail. It is why in this industry, where the failure rate of businesses is the highest in the United States, new companies have to understand the concept of profitability to survive and succeed.
Getting a good handle on the figures that determine how profitable your business is will go a long way in ensuring that you make enough money from each project and manage to stay afloat to build a great company.
This article will explain project profitability, why it's important, and how you can calculate it. We’ll also highlight the relationship between your profits and overhead costs.
Finally, we’ll share a few tips on boosting profit margins for your construction projects.
What is Project Profitability?
Project profitability measures how much money a project can make for your company after accounting for all costs. It refers to your ability as an owner/operator to yield a financial profit.
Contractors rely on understanding this concept to determine whether or not a project will be worth the time and resources needed for its completion.
The mistake is often made in believing that big-budget initiatives are highly profitable, but that is not always the case.
A project’s profitability depends on several other factors beyond just the budget.
This will be expanded on later when we explain how to work out the measurement of project profitability.
Project Profitability may be expressed in terms of:
- Profit --- the amount of revenue left after deducting all direct and indirect costs.
- Margin --- the percentage of the profit compared to income.
Why is it Important to Understand and Calculate Your Profits Per Project?
Understanding how something works is the first step in taking advantage of it for your benefit. Navigating the construction industry without knowing how profit margins work adds to the number of things out of your control.
But while factors such as the weather, inflation, supply costs, and labor shortages are out of your hands, you very well can get a grip on what your profits should be. The following reasons are why this is important.
1. Profits Aid Business Growth.
The whole point of trying to understand how profits work is so that you can replicate them more consistently. Consistent profit will inevitably lead to more funds being added to the company’s bottom line.
Increased net income can allow you to make further investments into the company, thereby contributing to its growth.
After calculating your particular profit margin, you can easily replicate those conditions and strive for consistency in your future projects.
This will guide you in making accurate forecasts and submitting competitive bids that include whatever markups you’ve arrived at from your calculations.
2. Profits Encourage Better Management Decisions
Determining the percentage of overhead costs that allows you to make a profit in line with the market average (such as how much you should pay for specific jobs) allows you to tailor your budget and recruiting efforts accordingly. It also helps you recognize errors in documentation and poor performance or spending areas.
The Relationship Between Profits and Overhead Costs
Overhead costs are the expenses incurred in running a business. For example, for construction companies, it covers the cost of executing projects and running the office operations of the business. Overhead costs can be categorized into two broad types:
- Direct Overhead Costs are the expenses assigned to a particular project. For example, the cost of building supplies and materials and project-specific salaries (of site engineers, supervisors, and subcontractors) fall under this category.
- Indirect Overhead Costs are the expenses that cannot be allocated to just one project. For example, the costs of doing business, such as renting office space, salaries of office staff, and payments for professional services (lawyers and auditors), fall under this category.
Because of its somewhat all-inclusive nature, understanding what overhead costs constitute has proven difficult for smaller and newer construction companies.
However, it is also necessary to understand your overhead costs as they go hand-in-hand with calculating project profitability. When creating a bid for a project, contractors typically include a markup. It is usually a percentage that accounts for all direct and indirect costs that the project will require for its completion and the expected profit margin.
This is where a sound knowledge of overhead costs comes in handy. Since the profit margin is left of the markup after deducting the overhead costs, arriving at a competitive market markup and, by extension, profit margin dramatically relies on how well you understand and allocate your overhead costs.
Average Gross Profit Margins in the Construction Industry
Gross profit margin measures your gross profit (after subtracting the expenses) divided by revenue and expressed as a percentage. It does not account for interest, tax, or other administrative costs.
Your gross profit margin will depend on multiple factors, and the market average is one of them.
Arriving at a definitive average gross profit margin figure for the construction industry is difficult due to its unstable nature. As a result, this figure or range varies from one construction business sector to another. It also varies based on your location.
Research into the market average in your sector should be carried out to set a competitive amount for your own company.
Typically, gross profit margins in the construction business range widely from 4% to around 45%.
Commercial construction projects yield the lowest margins compared to residential projects, averaging around 10%. There are various factors, including building material costs, length of projects, etc.
Home construction projects typically rake in a gross profit margin of around 14.9%, while remodeling and other specialty work yield between 34 and 42% profit margins.
How to Measure and Calculate Profitability for Your Construction Projects?
A few methods can be used to calculate your profitability. One of the most accurate and widely used metrics for evaluating project profitability in the construction industry is a measure of Net Profit Margin.
To correctly utilize this method to forecast the profitability of a project, it is mandatory to have a detailed view of all resources available to the company and all expenses (overhead costs) incurred.
The net profit margin is calculated by subtracting expenses, overhead costs, and taxes from the available revenue.
A General Contractor bids $50,000 for a small remodeling project, and the bid is accepted.
This bid also includes a markup that has accounted for a 10% overhead and 10% net profit margin, according to the 10 and 10 rule, on top of the challenging job cost of $40,000.
- A 10% overhead = 10% of $50,000 which gives us USD 5,000.
- Net Profit = Revenue - (Job costs + Overhead costs)
= $50,000 - ($40,000 + $5,000)
= $50,000 - $45,000
Net Profit = $5,000.
Therefore the net profit margin can be calculated thus:
- Net Profit Margin = (Net Profit/ Revenue) x 100%
= ($5,000/ $50,000) x 100%
Net Profit Margin = 10%.
A Net Profit Margin analysis, as shown above, can be used to determine what percentage markup to include in your bids and verify whether you’re on track to achieve your target profit.
5 Tips to Boost Profit Margins for Your Construction Business
In this section, let’s look at proven ways to improve the profit margins for your upcoming projects.
1. Define Your Goals:
Having a clear target for your financial goals is necessary when trying to better your profit margins.
What are your targets over the next year? And the next five after that?
Defining your profit goals will go a long way in helping you carry out practices that align with those goals.
It will also allow you to build sustainable and sound financial habits that will aid the growth of your business.
2. Understand Your Numbers:
As we mentioned earlier, overhead costs and profits in business go hand-in-hand. Therefore, a complete grasp of your office’s operational expenses and the costs of executing projects leaves you with a clear view of where your money is going.
With this, budgeting decisions are made easy. You can identify what needs to be cut or what requires additional funding.
It is not enough to estimate expenses and markups when you want to improve your profit margins. Instead, you should thoroughly evaluate your overhead costs and expected gross and net profit margins and compare them to subsequent figures. Any inconsistencies can then be instantly recognized and addressed with the relevant action.
3. Leverage Trade Credit:
An indispensable practice advantageous to small and new construction companies is that of trade credit. It is a short-term financing option that allows contractors to obtain construction materials and supplies upfront, with the payment to be made to the supplier at a later date agreed upon by both parties.
In cases where the supplier offers payment discounts to encourage early repayments, you can further exploit this to increase your profit margins.
4. Prioritize Profitable Projects:
Carrying out a profitability analysis on potential projects will help you pick out the ones with healthy profit margins before you embark on them. When handling more than one project, it is advisable to prioritize the ones with higher profit margins.
Focusing your time and resources on the initiatives that will yield good profit margins is one way to ensure a boost in those numbers. In addition, the expenses incurred while working on projects with marginal or break-even profits will be saved, thus providing additional profits elsewhere.
5. Avoid Competing on Price:
In construction, where you offer the same services as the other local companies — pricing is a standard front that you might use to compete. Unfortunately, this assumption leads contractors to submit bids with markups that barely earn them any profit or manage to help balance the books.
But it is a practice that should be avoided as much as possible, as it prevents you from recording healthy profit margins or growing your business. It is not a sustainable way of operating and could very well lead to the company’s failure.
Understanding project profitability and profit margins in the construction industry plays a massive role in the success or failure of businesses in this industry.
The dynamic and ever-changing nature of the construction industry makes it challenging to navigate for small and new construction companies trying to stay afloat and make a profit. Acquiring knowledge of the numbers, concepts, and practices that guide the market is a surefire way to ensure your company's survival and growth.