Introduction to profit targets

The aim of the JACK finance series is to help builders and tradies understand the true financial position of their business. We want you to feel comfortable discussing financial terms and know that your business is on track to meet your financial and personal goals.

In our earlier article Understanding profit in your building and construction business, we defined gross profit and net profit. So, if you need a quick refresher before diving into builder’s margin and markup please click here.

Understanding builder’s margin and markup

The terms ‘builder’s margin’ and ‘markup’ are both used to describe how much a business earns when looking at the revenue and the direct costs (building materials and labour), but they are calculated differently and provide different types of financial insight.

Builder’s Margin (Gross profit): Measures how much out of every dollar of sales a business actually keeps. It is calculated based on a percentage of the selling price.

Markup: Refers to the percentage added to the cost price of goods to cover overheads and profit. It is calculated based on the cost of the item.

Now this is going to get a little numbers-focused, but bear with me. We are building the ‘foundations’ of our financial knowledge…get it…foundations. 😊

To explain the difference, we are going to use an example of a home being built for $750,000 and we are going to set a target for the builder’s margin (gross profit) on this job at 25%.

To achieve a builder’s margin of 25% on a job with a sales price of $750,000 we need the building materials and labour to cost $562,500.

To achieve a builder’s margin of 25% on this job we would need to charge the customer a markup of 33%. Below is a breakdown of the formula used to arrive at this markup.

Here is a breakdown of the formula used:

Understanding builder’s margin and markup

Hopefully, you now have a solid grasp on the difference between builder’s margin and markup. Now we can get to the exciting part, applying this concept to your business to ensure you are quoting your jobs correctly and achieving net profit at the bottom line.

Setting your profit targets

Some builders set a gross profit target %, quote all their jobs based on this number, and hope their gross profit figure will be enough to cover their overhead costs. This is the business equivalent of closing your eyes, saying a little prayer, and swinging for the fence. These builders are looking at the issue completely around the wrong way and one unforeseen event or estimating mistake could cause the business to fail.

To know what markup or builder’s margins you need to make, you first need to understand your overhead costs. Overhead costs, also referred to as operating costs or fixed costs are any expenses not related to a specific job. Think bookkeeper salary, sales and marketing costs, and office rent.

Once you have accounted for all your overhead costs, you also need to determine what percentage of net profit you hope to achieve. This is the money that can be used to re-invest in the business or be taken as owner drawings.

According to the Association of Professional Builders (APB), larger, more established residential builders can achieve and should typically aim to produce a net profit margin of 10%.

We have no affiliation with APB but there is an excellent video resource on builder’s margin here: https://www.youtube.com/watch?...

Calculating your required builder’s margin

Keeping all this in mind then, you should use the following formula to work out your required builder’s margin.

Required builders’ margin = Overhead costs + Desired net profit

So, let’s say for example ABC Builder Co. has an estimated $7,000,000 of gross revenue in their pipeline over the next 12 months, they want to achieve 10.7% net profit for the year, and they have $1,000,000 of overhead costs projected for the same period.

The formula would look like this:

Required builder’s margin = $1,000,000 (overheads) + $750,000 (10.7% of $7m)

Required builder’s margin = $1,750,000

ABC Builder Co. would then need to apply a builder’s margin of 25% across each job to achieve the desired net profit of 10.7%. If any costs come in over the estimated amount this will erode the net profit for the period.

I hope this simple example has helped you understand how to set your profit targets. We would love to hear from you and discuss how you approach this problem in your building or trade business.

Liam Cook is JACK’s financial management expert. 

With 10+ years of experience as a chartered accountant ranging from small business advisory to CFO of an ASX-listed company, Liam can provide important insights into the financial management of your building or trade business.