One of the most important things to know and understand while owning a construction or home service business, is the difference between Markup and Margin. While the concept can be simple to understand, actually applying and mastering it can be more difficult.
So what is the difference? Markup refers to the percentage amount by which the cost of goods and services is increased to arrive at the selling price. Margin is the percentage difference between the selling price of a product or service and its cost of acquisition. Simply put, markup is just a number to increase price, whereas margin is what you will actually make upon selling and performing a job.
Definition and Calculation
How exactly is markup calculated?
In the context of construction, markup is commonly applied to cover not only direct costs like materials and labor, but also indirect costs such as overhead, administrative expenses, and profit. It is calculated by:
Your Markup Percentage is whatever you determine. So if it’s 20%, it’s 20% or if it’s 50%, it’s 50%. Nothing complicated about it.
To calculate your Selling Price, you can use this formula:
Selling Price = (1 + (markup%)) * Purchase Price.
For example, if a material has a cost of $100 and a markup of 20%, the selling price would be $120. (1.2) * $100 = $120.
Why is markup used? It is easy to calculate. Easy to have people understand and do it in the field. However, it does have shortcomings relative to margin.
How exactly is the margin calculated?
This can be a little more complex, but once you understand it, you can apply it and make more money. It represents the profit margin or the portion of revenue that contributes to covering operating expenses and gathering profit. The margin is typically expressed as a percentage and is calculated using the following formula:
Margin, or Profit Margin Percentage = ((Selling Price - Cost Price) / Selling Price) X 100
For example, if a product has a selling price of $120 and a cost price of $100, the profit margin percentage would be 16.7%. ((120-100)/120) X 100 = 16.7%.
Now, if you want to calculate out the price at which you should sell a product to get a desired margin, you would need to use the following formula:
Cost Price/(1-Desired Profit Margin) = Selling Price
For example, if you have an item you bought for $100 that you want to sell at a 50% margin, your formula would be $100/(1-.5) = $200
The calculation process may seem complicated and complex, which is why many people prefer to use margin calculations. However, if you want to maximize your profits, you should focus on margin calculations.
The good news is that there is software available to help you with these calculations. MotionOps is a tool that can assist you in calculating labor and material markups.
Issues with Not Properly Understanding the Difference Between Markup and Margin
Let’s walk through an example. If you do a 50% markup, many contractors will assume that they will make a 50% profit at the end of the day, but they don’t. With an example of $100 and a 50% markup, our sales price is $150. Now, let’s calculate what our margin on this transaction is, (($150-$100)/$150) x 100= 33.3%.
So when we think we are making 50% with markup, it means we only make 33.3% margin or profit at the end of the day. This is why properly calculating margin is important. Markup is not what you make. It is just a way to calculate how you want to increase your price. Margin is a superior way to calculate what to increase your sales price to in order to calculate what you want to make.
How to Calculate What Your Sales Price is Using Margin
If you want a 50% margin, using our example, here’s how you would figure out what your sales price is.
Cost Price / (1-%)
So, using our numbers from before $100 / (1-%) = $200.
If you want to get a 50% margin at the end of the day instead of charging $150, you will need to charge $200. Understanding the difference between these formulas and calculations at the end of the day will make a big difference in your company’s bottom line.
How to Calculate What To Charge:
To begin, we must understand some terms. Gross margin is the margin or gross income left after you add your company revenue and add in all expenses directly associated with producing that good or service. In the example of construction, gross expenses directly associated with construction are typically labor and materials provided for a project.
Company overhead is all company expenses not directly related to a specific project. They are all expenses that are typically incurred as part of running and managing the business. These expenses are often manger salaries, office expenses, marketing, software expenses, rent, etc.
A few steps to figure out what to charge to attain a given net income goal.
Historically review what your company overhead is as a percentage of revenue over the last 6 to 12 months. With this data, you can begin to accurately state that your overhead is 20%, 30%, 40%, etc.
Figure out what you want your target net income to be. A sustainable business in construction is 10%. A strong and healthy company is usually around 20%.
Subtract those two numbers(overhead and desired net income) from 100% to find out what your target gross margin is.
As a business owner you have to know your numbers. For example, if you know your company overhead, or expenses not included in the labor and materials part of a job is 30%, and if you want to make 20% margin at the end of the day. That means, you need to quote for a 50% margin, or a 100% markup in your estimates to make the 20% net income at the end of the day. Given, this is assuming you have a perfect world with no lost materials and no inefficient labor. You may want to factor for that in other ways with a 2-5% buffer.
Let me run you through some examples. If you want a 20% net income after your 30% overhead, that would mean that you need a 50% margin on your jobs. To calculate the 50% margin, on $100 in labor, here is how you would calculate your pricing using the formula above:
(1-.5)/$100 = $200 for your labor
On $200 in materials, you would calculate it this way:
(1-.5)/$100 = $400 for your materials
This will provide you with some tools to properly build your estimates and calculations.
Really Understanding Markup and Margin:
Markup and Margin are related but they are not the same thing. Your goal as a company is to attain margin. Markup is an easy way to get there. There is a relationship, but Margin is king and Markup is like the red headed step cousin that confuses everyone and things she is all that but she’s really just not that good looking.
So, here are some relationship numbers to illustrate:
A 100% markup is a 50% margin. A 50% markup is a 33% margin.A 20% markup is a 16% margin.
If at the end of the day, your business is not making as much money as you would like or hope and you keep thinking you are doing everything right, but the math doesn’t add up, takes hard look at what you are using to build your estimates. Are you using markup or margin? Again, markup is for vanity, margin is for making money.
Other Ways to Look at Costs To Boost Bottom Line
One common error is overlooking indirect costs such as overhead, administrative expenses, and profit when determining markup. Failing to include these costs can result in underestimating the total project expenses, leading to insufficient markup and lower profit margins. Another frequent mistake is not considering variability in project factors such as material prices, labor rates, and project scope changes. Ignoring these factors can lead to inaccurate markup calculations, affecting profitability. Additionally, relying solely on historical data or industry averages without considering project-specific requirements and market conditions can result in misaligned markup and margin projections, impacting the financial health of the construction business.
To avoid errors, ensure comprehensive cost estimation by meticulously documenting all project expenses, including direct and indirect costs. Utilize project management software or cost-estimating tools to streamline the process and improve accuracy. Conduct regular reviews of pricing strategies and adjust markup percentages based on changes in market conditions, project complexities, and business goals. Stay informed about industry trends, material price fluctuations, and regulatory changes to make informed decisions. Finally, seek feedback from experienced professionals or consultants to validate markup and margin calculations and identify potential blind spots or errors.
Industry Standards and Best Practices
In the construction industry, there are various industry standards and recommended best practices regarding markup and margin to ensure profitability and competitiveness. One common practice is to use standardized margin or markup formulas based on project type, size, and location. These formulas take into account factors such as material costs, labor rates, overhead expenses, and desired profit margins to determine an appropriate markup percentage.
Another thing you can adopt into your company is just doing a “cost +” for every job. The "cost +" pricing model is commonly used in construction contracts, especially in situations where the scope of work is unclear or subject to change. It provides transparency to the client by ensuring they only pay for the actual costs incurred, while also allowing the contractor to cover their expenses and make a profit. One of the key advantages of the cost + pricing model is its flexibility, as it allows for adjustments to the project scope or changes in material prices without renegotiating the entire contract. The contract can be used as a cost plus your markup or cost plus your margin. It’s up for you and the customer to decide.
Technology and Tools
One of the best software solutions you can get is MotionOps. It streamlines project workflows, tracks project progress, and allows for more effective cost management. With built-in cost tracking and financial management features, contractors can monitor project expenses in real time, identify cost overruns, and adjust pricing strategies accordingly to maintain desired profit margins.
By utilizing MotionOps, professionals can increase accuracy, efficiency, and profitability in determining markup and margin. This ultimately contributes to the success of their construction projects and businesses.
Understanding the differences between construction markup and margin is crucial for the success of any construction or home service business. Markup is the added percentage to cover costs and generate profit, while margin is the percentage of revenue used to cover expenses and generate profit. Make sure when you markup materials, that you are making the margins that you want.
Modern tools and software, such as Motionops, can help construction professionals accurately determine markup and margin, increasing efficiency and profitability. Adhering to industry standards, best practices, and pricing models like "cost +" can ensure transparency, competitiveness, and financial sustainability.
By avoiding common mistakes, staying informed about market trends, and continuously refining pricing strategies, construction professionals can confidently navigate the complexities of markup and margin calculation, ultimately achieving long-term success in the industry.