Are You Pricing for Profitability?
There are many ways to go out of business, and bad pricing is probably one of the quickest. When contractors don’t have enough work, of course, they don’t make enough money. But when their pricing structure is wrong, they may find work that actually costs them money.
Every construction job entails four main direct cost elements: materials, subcontractors, your own labor, and other miscellaneous costs. To create a bid, a contractor should calculate these costs and then mark each up to recover a portion of overhead and provide an acceptable profit.
Cost Elements and Risk
Each cost element carries risk, but subcontracting, materials, and equipment rental can be budgeted fairly easily.
Subcontractors sign binding agreements backed by surety bonds, and suppliers and dealers usually provide firm quotes. Escalator clauses in contracts with owners can protect contractors against drastic hikes. State legislatures have enacted escalators for certain commodities, including steel, lumber, and asphalt.
But when it comes to self-performed labor, there’s no sharing of risk. Every mistaken estimate or bad forecast comes out of the contractor’s pocket.
The potential problems are many, and labor is scarce when it’s most needed, such as when a key employee quits, a crew churns out rework, the heavens open with rain, the bid used apprentice instead of journeyman rates, or the job needs two foremen instead of one. Most common is simply a misestimation of the time and duration of a task.
When subcontractors make mistakes, the contractor pays a price, but the subs share the consequences. When a contractor’s own labor is involved, the risk is the contractor’s alone. Labor also entails far more overhead than other cost elements, driving up the cost of mistakes even higher.
Discipline and Detail
Precise knowledge of costs is the foundation of effective pricing. Rather than trying to match a competitor’s price structure, figure out your own. Otherwise you’ll win jobs but lose money.
If contractors develop the discipline required to go through the details carefully and thoroughly, they can be confident in their estimates. How many hours will you need a bulldozer? Have you found the best price for one? Have you shopped material requirements and locked in quotes? Have you contracted reliable subs?
But while such costs are largely a function of the market, the labor market only provides guidance on rates. As for how long it will take to pave a mile of roadway, there’s no book to consult. The only useful guidance is the contractor’s own historical experience, which is why measuring performance is so important.
Determining Markup and Profit
Once you’ve calculated estimated costs, allocate overhead costs and then figure markups. But don’t just add up costs and tack on one overall markup. You’ll never find the right percentage because cost elements and their risks are different and specific. Each job should be evaluated independently, and the markup rationale should match the job at hand.
Contractors must also decide on how much profit to build in to their price. Profit projections need not be constant for every job, but should reflect the specific conditions of a construction company and the job itself. Will it take the company in a direction it wants to go, open up a market in a new county, cultivate an owner who’ll deliver more work?
These are concrete questions for every contractor. Base answers on your own company and its model, not on what the competition is doing.
Growth and Subcontracting
As contractors take on bigger jobs, they will find a natural shift toward more subcontracted work. Hiring subs involves proportionally less overhead, less risk, and lower markups than self-performed labor, thus allowing contractors to offer better prices to owners.
This trend has given rise to construction management firms which perform no labor at all, but instead manage subcontractors, including the general contractor (GC), on behalf of an owner.
Bigger jobs bring greater profits and bigger risks, but shifting away from self-performed labor allows a contractor to spread those risks among more entities.