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Economics Of The Business

The remodeling and rehabilitation industry does not have a set of widely known economic guidelines. This is unfortunate because failure to recognize and understand the economic facts of life inevitably leads to failure in business. There are a number of basic economic factors which have historically been learned only by trial and error, if at all.

Nearly all successful remodeling contractors have found that the minimum mark-up to stay in business is 50% of direct job costs, which translates into a 33% gross profit or gross margin (see table below). In fact, most successful contractors find that 67-75% mark-up for a 40-42% gross profit margin is essential if there is to be a net profit to the company after overhead, recognizing that overhead includes owners' and managers' salaries. This higher mark-up is particularly important as a company's volume grows beyond $500,000 per year.

Job Cost Mark-Up Total Price Gross Profit Margin

$1000 + 100% ($1000) = $2000 50% ($1000/$2000)

$1000 + 75% ($750) = $1750 43% ($750/$1750)

$1000 + 67% ($667) = $1667 40% ($667/$1667)

$1000 + 50% ($500) = $1500 33% ($500/$1500)

$1000 + 43% ($430) = $1430 30% ($430/$1430)

$1000 + 33% ($333) = $1333 25% ($333/$1333)

$1000 + 25% ($250) = $1250 20% ($250/$1250)

The mark-up for cost-plus, or "10 and 10", is more complicated to figure. To the basic $1000 job cost, first add 10% ($100) for overhead = $1100; then add 10% ($110) for profit = $1210 total price. This gives a 17.4% gross profit margin ($210/$1210).

Direct job costs are different and separate from overhead items, and include the following:

LABOR includes all the people hired by a company on an hourly basis as workers on a particular job. The labor figure includes not only the cost per hour for an employee before deduction of withholding tax and Social Security, but all fringe benefits as well.

Fringe benefits include at least Workers Compensation and Social Security, and may include all paid holidays, vacation, medical benefits, even a vehicle provided by the company. All these fringe benefits must be calculated and pro-rated over a standard 40 hour work week to arrive at a correct cost per hour for a worker. Here is an example:

Basic hourly wage $15.00

Social Security @ 7.65% = $1.15

Workers Compensation, Unemployment @ approx. 23% * = $3.45

Hourly subtotal = $19.60

8 paid holidays

8 x 8 = 64 hrs x $19.60 = $1254.40/2000 hrs per yr = $0.63

2 weeks vacation

80 hrs x $19.60 = $1568/2000 hrs per yr = $0 .78

Medical Benefits

$150 per month/172 hrs per month = $0.87

Truck provided by company

depreciation $300/month

insurance $100

gas and oil $150

maintenance $ 75


$625 x 12 = $7500/2000 hrs per yr = $3.75

Actual Total Cost Per Hour $25.63

* varies by state and by trade

MATERIALS costs must include sales tax and delivery as well as the actual cost. If you buy and store materials, the cost of storage should also be included in your direct job costs.

SUBCONTRACTOR costs generally include electrical, plumbing, heating and air conditioning, painting, drywall, masonry, and sometimes even carpentry. If a subcontractor does not carry workers compensation, and you must cover it with your own insurance, that is a direct job cost to you.

PLANS, PERMITS and FEES include any cost for design of a job, and the permit fees including those which are passed on by subcontractors such as plumbers or electricians. Watch out for rapidly rising permit fees in many areas. Chances are it will not be uncommon to pay $2000 in permit fees for a $30,000 addition.

CLEAN-UP costs may be figured as part of the labor cost or they may be subcontracted as a separate item.

FINANCING costs are generally carried as part of overhead, but some fire insurance contractors and public sector rehab contractors who have substantial capital requirements may include the cost of financing for an individual job in their direct job costs.

One of the most important reasons the minimum 50% mark-up is necessary is that a remodeling business is actually a retail service business that requires a tremendous amount of customer communication and coordination. New home builders, who really are contractors and not retailers, can often work with a 20% gross profit and still make money.

Commercial contractors who are working with sophisticated purchasing agents can produce a net profit with a 10% gross profit. But the remodeling business is very different from new home or commercial contracting, and failure to recognize this can be the downfall of even the best estimator.

Most remodeling contractors do not realize their true worth as professionals in what they do, as "house doctors." Few contractors succeed without working 75 or 80 hours a week, and most small contractors working such a schedule would probably double their present take-home pay if they simply paid themselves an hourly wage equal to what they pay their best tradesmen. For example:

40 hours @ $18/hour = $720/week or $37,440/year

80 hours @ $18/hour = $1440/week or $74,880/year

Remodeling and rehabilitation is a time-consuming, relentless, exasperating business, and it's just too tough to stay in if you can't take out a very good salary plus a net profit to the business.

Experience with all sizes of operations throughout the country shows that the average overhead for a small contractor is about 30% of gross volume (see example next page), compared to a typical overhead for a new home builder of approximately 15%. Important factors include 7-10% for sales cost and 5-7% for job supervision; these are not a part of direct job costs.

Many contractors include a 2-5% advertising cost as well, so it is clear that overhead can reach 22% even before counting such costs as trucks, rent, telephone, insurance, legal or accounting fees, etc. This is why anyone who sells at less than a 33% mark-up for a 25% gross profit is losing money on every job, and why a 50% mark-up for a 33% gross profit is necessary to succeed at all in the long run.

As the professionalism revolution proceeds into the next century, the cost of being professional is increasing overhead. It is not uncommon for a contractor's overhead to be 35%, or even higher. Of course, this level of overhead requires a minimum mark-up of 67% for a 40% gross profit.

Overhead Calculations

ANNUAL VOLUME: $100,000 $250,000 $500,000 $1,000,000
1. Sales, 7-10% 7,000 20,000 50,000 100,000
2. Production Superv., 5-7% 5,000 15,000 30,000 60,000
3. Advertising, 1-5% 1,000 5,000 19,000 50,000
4. Rent, 1-2% 1,200 5,000 10,000 19,000
5. Office Staff, 4-8% 4,000 15,000 30,000 60,000
6. General Insurance, 2-3% 2,000 4,000 12,000 22,000
7. Truck (Sales, Mgmt. only) 5,000 10,000 15,000 20,000
8. Telephone 1,200 2,400 3,600 5,000
9. Radiophone, beepers, etc. 360 720 1,080 1,440
10. Tools & Equipment, 1% 1,000 2,500 5,000 10,000
11. Office Equip., lease/rent 500 1,200 2,500 5,000
12. Office Supplies 100 250 500 1,000
13. Accountant, monthly ret. 300 600 900 1,200
14. Legal Fees 500 1,000 1,500 5,000
15. Dues, Associations 250 500 500 500
16. Educ., Seminars, Travel 500 1250 2500 5,000
17. Entertainment 100 200 500 1,000
18. Bad Debts, 1% 1,000 2,500 5,000 10,000
Total Overhead Costs: $31,310 $87,000 $185,880 $374,340
Percentage of Volume: 31% 35% 37% 37%

In the service oriented, labor intensive remodeling business, overhead rises not only as an absolute figure but as a percentage when volume increases. There are several reasons:

As the business grows larger, job site efficiency does not go up, but actually decreases.

As volume goes above approximately $500,000, a one-person operation will have to hire a production supervisor who will probably not be quite so efficient or effective as the owner, and so job efficiency goes down while the cost of another employee is added.

A nucleus of efficient workers is usually developed in the first few years of a business, and as the business grows, new employees must be added who almost certainly will not be as efficient as the original nucleus.

The paperwork necessary to keep track of a business which has grown too large to be carried in one person's head certainly increases overhead costs.

Most large contractors, over $500,000 per year, find that their overhead is 35% of gross volume instead of the 30% experienced by smaller contractors. If a business does not recognize the need for additional administrative controls as volume grows, that business will probably fail. This $500,000 to $1 million volume range is often called "never-never land," and it is the most dangerous time for a business after the first year.

Economies of scale do not provide job efficiency for individual jobs any more than for the business as a whole. Many people believe that as job size increases, the gross profit margin may be reduced. While this would be true for a very large job involving only one trade, the exact opposite is actually necessary on the usual multi-trade larger job in remodeling and renovation. There are several reasons:

There are more chances for hidden costs in larger jobs.

The percentage of time required for job supervision is usually much greater on large jobs, because more details must be coordinated into a finished product, more trades must be organized into a job schedule, and there is more opportunity for crews to lose the rhythm of a job.

The likelihood of misunderstandings with a customer increases enormously as job size increases.

All these things mean that cost overruns are much more likely, and must be reflected in the original estimate.

When a company has determined a fairly consistent overhead percentage, it is important to cover that figure in any bid, plus a net profit on total volume. If a company plans to do $300,000 of volume with an average job size of $10,000 and a 33% gross profit, but then it takes two or three $30,000 jobs on which the gross profit percentage is reduced, that company will either lose net profit or have to hire additional crews to increase volume so as to meet its overhead.

The key fact to remember is that overhead does not tend to vary much from moderate sized jobs to larger jobs, so margin should not be reduced on larger projects.

Very small, handyman type jobs are a completely different category. The percentage of time required for set-up and estimating is quite high compared to larger jobs, and the mark-up and margin required are also quite high. On jobs under perhaps $2000, at least a 100% mark-up for a 50% gross profit is necessary to stay in business. Just one small mistake, problem or complaint on a $1000 job can eat up so much of the profit on the job, that the higher mark-up is vital.