A deep dive into construction gross margin
The motto of this week’s episode is: there’s nothing gross about gross margins. We’re defining gross margin (we also touch on gross profit, net profit, markup, and the differences between all of these often confusing terms). We’ll also fill you in on why gross margin is important and why consistently tracking yours is crucial.
Topics we cover in this episode include:
- What is gross margin?
- The difference between gross profit and net profit
- Markup vs. margin
- What you can learn from your gross margin
- What can cause swings in gross margin
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Rob Williams, Profit Strategist | IronGateESS.com
Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | McWins.com
TRANSCRIPT
[00:00:00] Rob Williams: Welcome to the Contractor Success Forum. Today we’re taking a deep dive into construction gross margins.
On the Contractor Success Forum, we discuss how to run a more profitable, successful construction business. And with us, we have Wade Carpenter, Carpenter and Company, CPAs and Stephen Brown with McDaniel-Whitley Bonding and Insurance Agency. And I’m Rob Williams with IronGate Entrepreneurial support systems.
And today is a deep dive on construction gross margins. Man, that has been a deep discussion for the whole career I’ve been in even all the way back to estimating in high school. How much did you make on that job? What was that?
[00:00:50] Wade Carpenter: Right, right.
What is a gross margin?
[00:00:52] Stephen Brown: And define, if you would, Wade, what is a gross margin?
[00:00:56] Wade Carpenter: Well, the calculation is relatively simple, but the factors that go into it can be tricky and that’s why we’re talking about this a little bit today. But the calculation is simply, hey, here’s the construction revenue we got, here’s the cost of sales that went into it. You strike that off and that net amount is the gross margin or gross profit, if you will. And if you take that number, that gross profit number and divide it by the total sales, that is your gross profit percentage. So that’s a simple calculation, but it can be very confusing.
[00:01:31] Rob Williams: Let’s talk about that for a second, because one of, actually the most common questions I get are like the words, gross margin, margin, profit, net profit, gross profit. Which, which ones? And I actually hear it used incorrectly sometimes, and then just the word gross sometimes will come out. We know that, and you just said the revenue that you take in minus your cost of goods sold equals gross profit. Well, what else do you call that? Gross margin. And then gross profit sometimes is, some people mean net profit , but correctly speaking, Wade, how would you, you’re the accountant– well and you’re the bonding guy too. What are the correct words they should be using?
[00:02:13] Stephen Brown: Well, I see gross profit so much on the–
[00:02:17] Rob Williams: And you see it every day.
[00:02:18] Stephen Brown: I think of it that way, but you know, maybe we should change the title of this to there’s nothing gross about gross margins. It’s a beautiful thing to have that and so Wade, tell us a little bit–
[00:02:30] Rob Williams: I hear butterfly music playing in the background, Stephen. That, that’s beautiful.
[00:02:34] Stephen Brown: You know, I, I try to be positive on this podcast. But Wade, what is it that we need to know that we can learn from studying our gross margin, our gross profit? And what it means to the profitability of our company?
Difference between gross profit and net profit
[00:02:48] Wade Carpenter: Well, just to kinda go back to what Rob was saying, the difference between gross profit and net profit is really your overhead. And that’s part of where the misconception is of what should go into job costing. Because some contractors define it as this direct cost of labor materials, subcontractors. But a lot of times there’s other things that should be allocated, truck, equipment, you know, depreciation, those kind of things.
But–
[00:03:16] Stephen Brown: Everything you allocate to a job cost, is that part of your gross margin?
[00:03:21] Wade Carpenter: Absolutely. Yes. And like I said, the difference between gross and net is that overhead. So defining what goes in which bucket can skew this. And part of the misconceptions and the problem is people being consistent in where they place certain costs.
[00:03:42] Stephen Brown: Right. From an insurance standpoint, I try to get people to understand, take your worker’s comp and general liability. It’s based on payroll, and tie it to job cost. Sometimes it’s hard to do that for specific pieces of equipment or vehicles. And then you still have the problem of your contractors understand that they do have overhead. It’s real and it’s something you’ve gotta account for and bid in your jobs.
[00:04:08] Rob Williams: And to clarify that definition, the specific thing I hear is they say, well, this is my gross margin. So then they think gross profit can’t be the same thing. So then they naturally think gross profit is net profit. So gross margin and gross profit, if you use those two words, are the same things.
[00:04:27] Wade Carpenter: Yeah, they can be used interchangeably.
[00:04:29] Rob Williams: Yeah, and some people will say margin means a percentage, but I, I think we’re really splitting hairs. When you say 30%, well that’s gross margin, and then a dollar amount’s profit. But I don’t know that that’s true.
[00:04:41] Wade Carpenter: Right. And there’s another concept that of contribution margin that I don’t really want to go into today. I wanna stay on the deep dive here.
[00:04:49] Rob Williams: Yeah, sorry. I wanted to get into there, I know most of you listeners know this, but for the ones that don’t, most people are too embarrassed to ask that question. So you don’t have to ask, because we told you gross margin and gross profit are the same. Net profit is that one after the overhead, just in case you’ve been confused on that somewhere because you hear other people use it improperly.
[00:05:12] Stephen Brown: And you may wanna listen to our podcast on financial ratios.
[00:05:15] Rob Williams: Yes, that’s right. All right.
[00:05:18] Stephen Brown: A lot of terms thrown around in that episode.
[00:05:20] Rob Williams: All right. Well, great. Okay. Now that we have that one cleared, do we have our definition, Wade? Is that our definition of gross margin cleared up?
Markup vs. Margin
[00:05:28] Wade Carpenter: Well, I think there are definitely some differences and I do think there is a big difference in markup versus margin.
[00:05:37] Rob Williams: Definitely.
[00:05:38] Wade Carpenter: we take a simple example of say you bought something for a hundred bucks and you’re gonna sell it for 120 bucks. Well that difference, that $20 difference is a 20% markup, but that is not your gross margin. Your gross margin is 120 minus 100 is $20, divided by your total sales, which would be 120. So that gives you a 16.7% gross margin. And a lot of people really think, hey, I’m, I’m getting 20%. When they’re not really getting that. They don’t understand the calculation. Does that make sense?
[00:06:20] Rob Williams: It really does. And I think when we learn accounting, we start with revenue and then we’ll say, oh, the percent of the revenue is 20% gross margin, or say it’s 25, let’s just say it’s 20%. So we think 20% would be our markup, and then that’s not right because that’s the way we tend to learn it.
Revenue, and then going down, revenue minus your cost equals margin. When we get in the real world, we start with the cost. So it’s backwards. So you’ve got the cost first, because you estimate how much it is and then you determine your price, most of the time. You usually don’t know the price first.
Dad used to always tell me, just hit the divide button. That’s all I remember. It’s the divide button. And so you have to say one minus the 20% is 80%, so you divide by 0.8. And that’s a big difference because like you just said, and, if you have a bigger margin, say it’s a 25% margin, well that’s gonna be a 33% markup. And the larger you go, the bigger the difference.
And I can’t believe how many experienced people still don’t get that. So when you’re reading your financial statement, you’re multiplying the revenue times that percent gives you the gross margin, but you have to divide by one minus to use the correct margin.
[00:07:40] Wade Carpenter: Well, I think that’s just an indicator of some of the problems that a lot of people have in estimating. They think, hey, we marked it up X amount and I’m making 40%. And then their misconception about like overhead, which I know we could do a whole deep dive on that as well. But you know, they think that their overhead is X percent, so they’re not really making the numbers they should be making and they think they’re making.
[00:08:07] Rob Williams: Yeah. So maybe I can say that more simply. When you’re looking at your financial statement, those are as a percent of the revenue, where most of the time you want to know what they are as a percent of the cost. So you’re starting with your cost.
[00:08:22] Stephen Brown: Let me ask you this, Wade, and Rob too. So you’re a contractor and you’re bidding things tight enough that you think you’re gonna get the job. You have a breakeven point, you have a minimum amount of gross profit on the job, but you really feel in your heart and your bones you can just tweak out a little more profit in it. What are the problems with that versus someone that is crazy about their costs going into it? Knowing exactly what they are and providing a kind of a risk factor to that and still trying to to pull off consistent numbers. Did that make sense?
[00:08:59] Wade Carpenter: I think what you’re asking is, somebody that has a good handle on what their gross margin is and what goes into it. They know whether they can squeeze out that little, or they can cut that a little bit more.
[00:09:11] Stephen Brown: Well, that, that’s the game. That’s the game contractors play, is how do I make this job outperform my estimates? And what I’m hearing you both say is you gotta know that your estimates are right in order to battle them.
[00:09:27] Rob Williams: Yeah, that’s a big topic on, I think there were two parts to that question, but the big part is knowing your cost. And this is really a different subject, but sticking to what you know a lot of times, so you’ll know how to do it. I know one job that you bonded for me, we had one line item.
We did the HardiePlank that was pre-painted, didn’t exist in our catalogs yet. This was like the first one. So we put the wrong, we put the non-painted HardiePlank in there, and that took our whole profit out of the job. We weren’t used to doing these dormitories, and we were distributor of HardiePlank, but just the regular part, but it was something unfamiliar and we got it and, and we ate it.
But yeah, knowing what those are and, and sticking in your, where you are and having your systems and processes for that so you’re not just a desk just full of paper, all these calculations or even lost in the computer, that’s actually even more dangerous when you don’t know how your computer system works.
I’ve seen that, those are bigger systems because we used to actually have our rules of thumbs, so we would check with our, we may have 10 factors, some kind of square foot factor just to make sure we were in the ballpark to make sure there wasn’t some decimal point wrong. It, it just takes one tiny little thing in a computer to just be way off base.
What you can learn from your gross margin
[00:10:44] Wade Carpenter: I think Stephen hit on one of the points like, what can you learn from this? Can you learn whether you, you, can squeeze out that bid a little bit? But generally speaking, if, if you’re watching it over time and you’re consistent, you can tell if you’re winning or losing. You can tell if you know your margin is slipping or, usually it’s, it’s going the wrong way, especially with costs. But you know, if there’s ways to improve it and you’re trying to get more efficient, sometimes it can go the right way, but it takes consistently looking at it in the same way.
[00:11:15] Rob Williams: Yeah, I think finding your niche that’s profitable. I know we did a lot of lean manufacturing, so I guess we got a little overconfident. We were extensively lean manufacturers back in that day, so we pretty much thought we could do anything cheaper and better than anybody else. Yes, you can be really good and efficient at something, but I think there’s a huge factor of bidding the right jobs and the stuff that match you, that’s a bigger factor of the margin, I think, than your performance, which we completely, we, we didn’t put enough emphasis on bidding the right jobs. We thought we could do any job cheaply.
[00:11:52] Wade Carpenter: Well, that absolutely leads into situations where it’s not comparable because there are times where your gross margin may be fluctuating and sometimes it’s a mix of your jobs.
[00:12:06] Rob Williams: Yep.
[00:12:06] Wade Carpenter: I know Rob’s writing a whole book on that, but.
[00:12:09] Rob Williams: Yeah. The Pumpkin Plan For Contractors. Yeah. We had houses that are sticks to brick margin, which is a different margin. That’s one way our, just our hard direct cost that went in there. We had a little 101 plan, a thousand square feet. We made a 40% margin, and then we had some houses, we made 16% margin. I don’t know why we built those. They were real pretty and it was good. And the agents always said, we can sell it, but I don’t know why we were building houses that we made 16% margin on, but it was interesting. They’re drastically different.
What can cause swings in margin
[00:12:43] Wade Carpenter: The classic example is somebody that does general remodeling or something, and they make X amount on a kitchen and X amount on a bathroom and X amount on a basement. And if you do a whole bunch of basements in one year and you’re not doing something that might have higher margins like a kitchen, they can swing wildly. And if you’re not looking at the inputs that go into it, it can be very confusing.
[00:13:10] Stephen Brown: I think that answered my question about why there are these swings
[00:13:15] Rob Williams: Hm.
Hmm.
[00:13:16] Stephen Brown: Control those.
[00:13:18] Wade Carpenter: We talked about throughput in one of the episodes where how fast you can get in and out, that can swing that margin.
One of the other things is, you could have a construction management job where you have virtually no cost in it, versus one that’s heavy on the materials and subcontractors, versus your standard one where you do labor in-house.
A lot of those factors, you can’t say they’re apples to apples, and sometimes you gotta break down your jobs and do a gross margin job by job, or at least category by category.
[00:13:51] Rob Williams: Stephen, you and I had lunch with that underwriter that day, and his question was, how do people know how they’re doing on the job as it’s going? And only one time can I remember in one system, one of my companies, we actually had purchase orders and then we had variance purchase orders.
And that really worked out well because you had an ongoing track. Every variance purchase order, whether it was under or over, it was created. So we knew exactly where we were. It was a little bit of a burden, but we knew exactly where we were at all times. Every single invoice and it gave the computer, gave us a running system.
That was the only system that I used that did that. Usually, we just didn’t really know till we finished. We would wait till everything coming and then it was like, oh, is everything in, you think everything’s in? Okay, let’s see the mar– oh, great. We made money. And then a week later, two more invoices came in. We’re like, oh man, we didn’t make what we thought we made.
[00:14:44] Stephen Brown: Yeah, I understand that.
[00:14:47] Wade Carpenter: I know this sounds very self-serving, being the accountant in here, but can–
[00:14:52] Stephen Brown: The truth’s, the truth.
[00:14:53] Rob Williams: Yeah.
[00:14:54] Wade Carpenter: Of 30 years of doing this, I would say if I look at the contractors that are most profitable, those are the ones that are spending the time and understanding what their true job cost is and really getting a handle on it. And it’s something that, the owners do not want to spend time and money figuring this stuff, but they want the information. I guess that’s a common theme. I know it sounds self-serving.
[00:15:22] Rob Williams: No, that’s, it’s really important and yes we are self-serving on having people help you and do those things, but you know, you need it. Maybe you can do it yourself, that’s great, but at least know and have that vision that it is possible to know where you are on a job. I think some people just think that, they just assume it is what it is, and there’s no way to know that. So they don’t even know to reach out to a Wade or, or–
[00:15:47] Stephen Brown: And they don’t even know what questions–
[00:15:50] Rob Williams: yeah, they, yeah, they don’t know the–
[00:15:51] Stephen Brown: –to ask their professionals.
[00:15:53] Rob Williams: So what is that line, Stephen? What is your favorite line?
[00:15:57] Stephen Brown: You don’t know what you don’t know.
[00:15:59] Rob Williams: That’s right. You don’t–
[00:16:00] Stephen Brown: –know what you don’t know. But you also have to know how to ask for what you want from your professionals. This is everything.
I sit here as a bond agent telling you, honestly, I’m not a contractor and I’m not an accountant. And that’s the key to my success. I do what I do all day, day in and day out. But tracking the job costs and the variances of those costs is everything.
We’ve talked about that over and over again. It sounds so boring guys, and it sounds like such a headache, but there’s so much power in it now. It may not apply to you, it may not apply to your type of construction business, but I think this is a great topic, and listeners, if you listened all the way to this end, we hope you’re gonna get that point, that information that you need to understand to make more profit, that’s what we’re all about.
How to know if your gross margin is where it should be
[00:16:57] Rob Williams: Well, let’s, let’s talk about one of the other subjects, Wade, where they’re not comparable. What is the best way to find out how you’re really doing? I think, Stephen, the best way is when we’re at those conventions, we go to the bar and we talk to other contractors, and we say, how are you doing? What are you making? What’s your margin? Isn’t that the best?
[00:17:17] Stephen Brown: –that crap at the bar.
[00:17:19] Rob Williams: You don’t think that’s the best? Oh man. Well, we always talk about that at the bar.
[00:17:23] Stephen Brown: No. Maybe, maybe you and Wade do.
[00:17:25] Rob Williams: — my jobs.
[00:17:27] Stephen Brown: Maybe you and Wade do, but I, I, that’s not what I talk about at a bar. But No, I understand your point. What, what are your concerns?
[00:17:36] Rob Williams: When we talk about what we’re supposed to be making on these jobs and what is the market rate, how, what should our margin be? What should our markup be? Whichever one, right there is one word when you start talking to your bud s about this, I mean that, it’s funny that you get these reports, you know, but how accurate, where did those come from? And then you start talking to your friends and you start asking them, because how much are you supposed to be making? Your peers, that’s what you find out. Are those always the same, Wade? Is is one guy’s margin when he says he is making 25% and then the other guy down the street says he is making 25%, are they making the same amount?
[00:18:15] Wade Carpenter: Well–
[00:18:16] Stephen Brown: How do you know they’re not full of it?
[00:18:18] Rob Williams: Yeah.
[00:18:18] Stephen Brown: If they’re at a bar. If they’re at a bar, they’re making crazy gross profits.
[00:18:24] Wade Carpenter: Well, I’ve never met a business owner that, they, nobody wants to admit they’re not doing well and they want–
[00:18:31] Stephen Brown: That’s when you need to ask for help.
[00:18:32] Wade Carpenter: But it is very common to say, I’m getting all this margin. And sometimes you might be surprised. I know it’s always, what Stephen was saying, a game of if I make it too high, I’m gonna lose a job. But if you make it too low, you can wreck your company.
[00:18:46] Rob Williams: Yeah. Well seriously though, in answering this question, I used to be in some builder groups and some contractor groups and, and we would go around and we’d actually look at each other’s financials and that was really good. Most of them, you don’t get that deep, but we did have some that were very analytical and we started looking at margins, and that’s when a, a real big light bulb went off.
And I’m like, wait, you’ve got that up in your job cost. We don’t have that in our job cost. Or the reverse because we had a lot of stuff that we just didn’t know how to allocate. So it was part of our overhead. Like our advertising, we did a lot of big billboard and TV advertising. So we just had a line item that was down below and some people count that, some people count the commission to the agents in their job costs because it’s a direct cost. Some people don’t. Ours fluctuated, and it came out on the average, so ours was below the line because it was like sold in-house. We paid very low, but if it was sold with an outside agent, it would be double or triple.
So we just wanted to see an average. We didn’t wanna penalize those particular jobs, so we didn’t allocate it up there. So our margin appeared a lot higher than it–and even interest because we wouldn’t borrow on some houses and we borrowed all on another job, so all for us, a lot of that was below the line.
So when we got in those meetings, we realized, oh, when you’re saying 20, you mean 30. And, and I mean 30, I mean 20. So you’ve gotta know what you’re including in those gross margins. I don’t know if there is a standard, we didn’t use it if there was one. Is there a standard of what you put up there and what you leave down below?
[00:20:22] Stephen Brown: Well, that’s all we do is convince people in the bonding when someone wants to go after a job that they don’t normally do, and they say, I think I can make good profit. I’ve got a guy that’s done these type of projects before. This is some of what we do already. And the rest of it, we understand.
[00:20:39] Wade Carpenter: Yeah, well I think we’re back to the same question. Comparing apples to apples and I wouldn’t pay attention to what the guy down the street does. Just make it consistent for you. Generally Accepted Accounting Principles has some, pretty much some guidelines on those kind of things, but a lot of times it is still up to interpretation.
So again, get some advice on this, but be consistent.
[00:21:04] Rob Williams: Well, it did help me in the trade organizations sort of answering my own question. That’s how I started to really feel like I was in the right place of the margins. And then, depends on what you’re in, you may, it’s, it may be in a appraisal, a property, or if you’re, if you’re building for the market or something like that on what, what you’re gonna do.
But usually most of our contractors are not building to sell, I don’t think. So finding those out, finding some benchmarks. Maybe the bonding agents, they can figure out what the benchmark, the profit should be and hopefully you’re good with your costs. So I think it depends on which type of job you have and, and try to get with peers, trade groups, those kind of things to try to figure out where you should be.
[00:21:43] Stephen Brown: I thought that was a good comment about make it consistent for you. We’ll end it on that note because–
[00:21:49] Wade Carpenter: I mean, apples to apples.
Like I said, understand, sometimes you gotta break it out and segment it based on the type of job you’re doing, but it can teach you a lot and it can teach you if you’re slipping. And there’s so much to doing it. I recommend everybody take a deep dive, figure out what it is really for you and look at it regularly.
[00:22:11] Rob Williams: Right.
[00:22:12] Stephen Brown: Nothing gross about gross margin.
[00:22:13] Rob Williams: Yeah, that, that should be the title of this, this show. But–
[00:22:17] Stephen Brown: Thank you both.
[00:22:17] Rob Williams: This has been our Contractor Success Forum. There’s nothing gross about gross margins. So find us on YouTube. Please subscribe so we can help many other people see it. The more of you guys that help us by subscribing on YouTube, the more it’ll actually get out there for us. You’ll really do us a favor. Appreciate it. And then you can actually make comments on there too. We’d love to hear from you guys. So look on our YouTube channel. It’s Contractor Success Forum. And listen to our next show. We appreciate you.