Praying or Planning for Profit?

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The sad truth is that larger jobs, unfamiliar project types, poorly chosen clients, poor job costing - and the resulting repetitive estimating errors - capped by a poor understanding of how profit is generated, are the root causes of remodeler failure....

August 01, 2003

 

Alan Hanbury

Although the two are not necessarily mutually exclusive, getting down on your knees doesn't guarantee a profitable outcome. Many of us think that profit is the natural result of hard work or 60-hour weeks or selling in good neighborhoods or increased sales volume or larger jobs.

The sad truth is that larger jobs, unfamiliar project types, poorly chosen clients, poor job costing - and the resulting repetitive estimating errors - capped by a poor understanding of how profit is generated, are the root causes of remodeler failure. As usual, it breaks down to numbers: lack of numbers, poorly documented numbers or inaccurate formulas.

Click here for a markup calculator.

 

Scenario 1:

Not enough profit


Let's show the math on predicting profitable scenarios before the year starts. (This is called pro forma in business planning.) Assume the following:

 

 

 

  • 50% markup (the low end for professional companies)
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  • $1 million in produced volume (based on last year's results and a stable local economy)
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  • $300,000 minimum in overhead (notched up 5% from last year, including a reasonable owner's compensation of $100,000)

    Not every dollar past the break-even volume is profit. That last $100,000 in volume won't have to cover any extra overhead, but it will include labor and material costs. Therefore, it will add to net profit at margin rates, and this company has a pro forma net profit of $33,333, not $100,000.

    Dividing net profit by volume, we calculate a net profit percentage of 3.3%, which is certainly not a good target. How do we plan to obtain a 10% profit?

     

    Scenario 2:

    Increasing net profit


    You do not have to increase the number of jobs you do. Leave the cost of goods sold the same, but allow overhead expenses to be 30% of total volume to cover growth past $1 million. Then intentionally increase pricing and thus volume.

    Here is the math. Let's assume:

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  • 10% net profit target

    At the break-even point, overhead is 30% of total volume. Take that 30% and add to it your net profit goal of 10%. Your new gross profit percentage target needs to be 40%.

    To get that margin requires a 1.67 markup multiplier or 67% markup.

    The cost of goods sold was predicted at $666,667, so the new pricing predicts a volume of $1,111,334. Based on that number, overhead is $333,400. Deduct overhead and cost of goods sold, and we have $111,267 for net profit.

    That is 10% of the total sales, and we didn't have to complete one more job to accomplish it - except your sales job to get the better price!

     

    Scenario 3:

    Midyear re-forecasting


    Can we use this tool midyear, say today? You bet. Here's how it might work, starting from the financial assumptions of scenario 1:

    It's August. Two-thirds of the year is under your belt. You were targeting $1 million volume for the year, so you should be at $666,667 volume with $222,222 of overhead and profit covered. Instead, you are at $600,000 and have covered only $180,000 overhead and profit. The margin is sporting a 3.33% slippage to 30%! (This, by the way, is a very normal occurrence, and if unplanned always derails your year. To eliminate your average slippage, always use produced margin for pro forma financials.)

    Continuing at your current pace gets you to only $900,000 in volume, for a loss of $30,000 ($900,000 x .3 = $270,000, but overhead is $300,000). Doing $100,000 in volume per month for four months will get you to your original volume goal of $1 million, but if you do that work at your present 30% margin, the company will only break even ($400,000 x .3 = $120,000, which is what you need to cover the rest of your overhead).

    How can we salvage the year? We need to do more annual volume at a better margin now to make up for slippage. Let's decide:

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  • $300,000 maximum in overhead
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  • 10% net profit target
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  • 60% markup, 37.5% margin going forward

    We need to cover $120,000 of remaining overhead, plus net profit of 10%. What volume is required for the remainder of the year?

     

    A little math shows that $920,000 will get us to break-even, but that's not enough. Remember, after break-even, every dollar of sales produces net profit at gross profit rates; each dollar of sales over $920,000 creates 37.5ó of net profit.

    If you use a 50% markup (33.3% margin), your break-even is $960,000, new target annual volume increases to $1,371,429, and your new four-month target rises to $771,429.

    Unfortunately, at either markup, with such a large increase in actual dollar volume and a probable increase in the number of jobs completed, it is virtually impossible that overhead will stay at $300,000 as we have assumed (prayed).

    Remember, 10% net profit is impossible unless margin exceeds overhead percentage by 10 percentage points at a particular volume. Now get down on your knees ... and find your calculator.

     

    Note that at 25% margin there is never net profit if the overhead is 25% or more of sales. At 33% margin, net profit occurs at $900,000 in volume and rises 3.33% of every dollar thereafter, theoretically reaching $33,333 at $1 million. At that point, overhead changes to a percentage of sales, and net profit is simply 3.33% of volume. At 40% margin, net profit starts coming in at $750,000 and rises to 10% per dollar of volume starting at $1 million. It continues at 10% of sales until overhead rises above 30% of sales.
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