April 15th, or "Tax Day," is the day of the year that many business owners and contractors dread. Those with businesses and
those who help others with their businesses understand it's no picnic writing large checks to Uncle Sam and his relatives.
These professionals also understand that talking with accountants and/or tax preparers can be bewildering when strange-sounding
names (i.e. "marginal tax rate" or "alternative minimum tax") and long lists of numbers render vacant stares and heads nodding
in false comprehension.
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But these terms and numbers are important to business owners who strive to make their year-end price margins close to their
expectations. In this second of three articles that focus on helping contractors' businesses grow, we will take a look at
some important financial numbers and identify how these numbers help contractors run more successful companies.
Markup and margin
A common concern among many business owners is typified by the following statement: "I price my jobs for a 10 percent profit
but at the end of the year I'm lucky to see 3 percent." This statement is representative of a contractor or business owner
who confuses price margin (profit) with markup. To make your balance sheet tally at the end of the year, there are some basic
financial keys you do need to become familiar with. Markup is the price (or cost) times the percentage. A contractor or business owner estimates materials and labor for a job for $1,000
and marks it up 10% for profit. The total price for the job would then be $1,100.
Margin is calculated differently and defines how much profit a business owner will earn after materials, labor and overhead are
deducted. Margin is calculated as net income divided by revenue. Take the contractor who sells a job for $1,100 but wants
(and will budget for) a 10% margin for profit. Using the former example, the contractor will divide the total costs for the
job ($1,000) by one minus the desired margin (10%). The calculation looks like this:
$1000 / (1 - 0.10) = $1,111.11
Once this calculation is done, however, the contractor sees he'll only be receiving a 9% margin. If this is done on all of
the contractor's jobs throughout the year he will reduce his 10% margin to 9% at the end of year, all because of confusing
markup with margin. In order to receive a 10% margin, the contractor will need to charge $1,111.11 for the $1,000 job.
In addition to confusion in markup and margin, there are other factors that may have brought that 10% margin down to 3% at
the end of the year from the initial example. While there are several reasons for this, the following are often overlooked:
- Remember that big tax bill in April? That may be an indication that business owners are not correctly accounting for tax liability
during the year.
- Was significant debt paid off during the year because many jobs were secured and you're trying to be debt free? While that
can be an admirable goal, business owners must remember to account for that during the year to know what effect it would have
on the business by the end of the year.
- Speaking of that good year, were the business owner's best workers or supervisors given a bonus as a way to say thanks?
Profits explained
Businesses big and small use key financial information to help explain their current financial situations and to help point
to specific areas in their businesses to find improvements. Many contractors assess their current and future financial security
on financial ratios that can be determined by working with an accountant or by purchasing accounting software that automatically
calculates financial information. While there are several financial ratios contractors and business owners can use, two of
the most widely used are explained below.
