I recently conducted an email survey, and out of the 100 decorative concrete professionals who responded, nearly 50 percent could not tell me what their margins were without verifying first. This intrigued me. Essentially, five out of 10 contractors and distributors did not know with certainty the most important financial metric they have to determine the value produced for their business. And that means they could be losing money.
Value to your business (as opposed to value to your customers) is often called “profit margin,” which is the difference between price charged for a product and the cost of getting that service to the customer.
The value to your business is best determined on a per-unit basis. However, many contractors don’t exactly make widgets for their customers. So if your primary business is something like concrete staining, polishing or stamping, I recommend you calculate your margins on a per-square-foot or per-project basis.
You should know the price you charged. Just look at your customer bid or income statement. Calculating all the costs of delivering your product (“fully absorbed costs”) is a more complicated process, especially cost per unit. But it’s worth the effort — it ensures that you will be better equipped to navigate your competitive landscape.
Calculating cost per unit requires a combination of three types of costs: direct costs, indirect costs and overhead. Let’s break them down:
Direct costs can be completely attributed to producing an actual unit of your product — the installation service and the decorative finish. For example, direct costs include the amount you paid (expense) for your concrete stamps or stains. Did you use a brush to install the stain? Better add that cost in, as well.
Indirect costs or “variable overhead” are the costs of marketing and delivering your product to your customers. Examples include costs that cannot be directly allocated to a specific product, such as labor expenses, legal fees, print ads, expenses for equipment maintenance, or utilities. Generally, service-based businesses tend to have substantial indirect costs compared to their direct costs. They fluctuate somewhat with the level of your business activity. But remember, these costs are incurred even if business is slow.
Overhead is the fixed expenses of your business that are not included in direct or indirect costs. Rent, executive salaries and insurance are usually categorized as overhead.
Your total cost per square foot can be figured with a simple calculation:
(Total Direct Costs + Total Indirect Costs + Total Overhead) ÷ Total Square Feet Installed = Total Cost Per Square Foot
The cost allocation among these three categories may be somewhat arbitrary as long as the costs are fully absorbed, meaning that ALL costs in the production of a single unit (or square foot) are accounted for. You may have the receipt for your last tank of gas, but have you figured out exactly how many gallons of that gas were consumed (an indirect cost) to install one square foot of concrete stain? You may know your monthly payment for your power trowel, but do you know how much of that expense should be allocated to a single square foot of finished concrete?
This process may sound tedious or unnecessary, but successful contractors will take enough time to measure their costs so they can better understand how to finance and grow their business.
Here’s a simple example. Let’s say your direct costs (e.g. stamps, stains, hardener, etc.) for a given month were $1,000 and your indirect costs (e.g. part-time labor, depreciation expenses on your truck, advertising campaign expenses, etc.) were also $1,000. If your overhead (e.g. executive salaries, rent, utilities expenses, etc.) for the same month was $2,000, your total costs (i.e. Direct + Indirect + Overhead) were $1,000 + $1,000 + $2,000 = $4,000.
Now, let’s say you installed 4,000 square feet of decorative concrete in that month, Your cost per square foot was $4,000 / 4,000 square feet = $1 per square foot.
So far so good. If you charged your customers an average of $2 per square foot in that month then your gross revenue was $8,000 (4,000 square feet x $2 per square feet).
Therefore, your pretax net profit is $4,000 ($8,000 gross revenue - $4,000 total costs) and your net profit margin is 50 percent ($4,000 net profit / $8,000 gross revenue). Congratulations!
When consulting for small businesses, I offer a general rule of thumb for margins that can vary widely depending on the industry. Generally speaking, net profit is usually around 20 percent. Costs of goods sold (COGS), which is your direct and indirect costs combined, tend to be an average 50 percent of gross revenues. And overhead tends to be an average 30 percent of gross revenues.
The results of my survey are consistent with this general rule of thumb. More than 70 percent of respondents (who could actually recall their margins) indicated their net profit margin is more than 20 percent. This was good news, because if your margins are less than 20 percent you really need to ask yourself if it’s worth getting out of bed in the morning for your business.
There is virtually no substitute for knowing your costs per unit. Knowing this is what separates the business-savvy from the rest of the competition. Managing your business without this information is like going 10 rounds with Mike Tyson with your hands tied behind your back.
Let’s say your profit margins are 40 percent, which would probably be considered relatively high margins for the decorative concrete industry. A high-margin business has more room to sustain pressure from customers to discount the price. That is, when you find yourself engaging in a price war, your business will have room to maneuver. And if your fully absorbed costs are less than those of your competitors, then you can discount your price, still make a profit and win the job over your competition.
But what if your margins are only 10 percent? This represents a risk if you were to find yourself trying to bid against another contractor with healthier margins. Again, this is reflected in the results of my survey. Approximately 30 percent of respondents indicated their margins are less than 20 percent. And 30 percent said they have to discount their price due to competition or pressure from customers. Where margins are smaller, it will be exponentially more difficult for you to manage, finance and earn from your business.
If you struggle with the exercise of calculating your margins, you’re not alone. For most business owners, it’s about as exciting as a colonoscopy. Just make sure you have access to a competent accountant who can help you navigate your income statement. Take time early on to establish procedures to measure this information while your business is relatively small. Then it will become easier to finance the growth of your business. This effort will pay big dividends down the road.
Four Profit Margin Tips
• Calculate margins on a per-unit or per-square-foot basis.
• Hire a competent accountant if you struggle with calculating your margins.
• Establish procedures that will help you better measure your margins.
• If your profit margins are less than 20 percent, it’s maybe time to rethink the viability of your business.