The 4 Modes of Profitability for Contractors

Publisher’s Note: Welcome to an all-new series in C&R exploring the hot topic of Overhead & Profit – O&P. This series will bring together articles from several industry experts who specialize and train on estimating, getting paid, and legal matters.  

In my 20+ years of experience working in this industry, I have observed and participated in the rise as well as the fall of many business ventures. Everyone who starts a business knows profitability is important, but too often contractors treat it as optional. This article will be the first in a series to attempt to help new entrepreneurs, in-progress contractors, and aspiring persons in a position of leadership to better grasp the essential nature of overhead and profit (O&P) within the skilled trades. The reader will help themselves and their team members form better mindsets and habits as they think through the four modes of profitability for contractors. 

Survival Mode (No Added O&P)

Somewhere between years three to nine, a tradesperson starts to think seriously about going out on their own. Perhaps they have maxed out the salary structure in their current organization or they feel they could get a bigger piece of the profit pie if they were the ones cashing the checks for themselves. Whatever the final motivation is, too many contractors don’t fully grasp what it takes to operate and grow as a profitable business venture. The author of the best-selling book, The E [Entrepreneurial] Myth, Michael Gerber puts it this way,

“If your business depends on you, you don’t own a business—you have a job. And it’s the worst job in the world because you’re working for a lunatic!”

If our new business “owner” was making $25 an hour as a tradesperson, when they go into business for themselves, what do you think they will believe is a good rate to charge for their services? I’ve heard as low as $25, more commonly in the $45 an hour range, and usually capping out in the $75 an hour range. 

Unfortunately, this pricing often carries into multiple years of business as many contractors, who are skilled at what they do, are afraid to raise their prices. In survival mode, the primary need is a paycheck. Please understand that I am not denigrating this reality. I have been there and there is nothing more important, especially if the contractor has a family. But, if the contractor isn’t thinking beyond their immediate needs, they are not operating as a business. The contractor in survival mode needs to adapt their mindset and habits to see overhead and profit through the eyes of a business person.

The cost considerations at the survival stage:

• Labor: If our new entrepreneur was making $25/hr, the thought often follows – if they can pay themselves anything more than that, they are headed somewhere. This is true and false at the same time. While they would be making more, if they aren’t putting anything away, at the end of the year the first of their problems will be the taxes on their revenue. If they make close to or slightly above what they made as an employee, their taxes will be higher than last year because of self-employment rates.
• Materials: So many new contractors pride themselves in charging their customers “cost” for materials. Yet, they also only charge for their time onsite so they are actually losing money when they run to the store for those items, pick them up, and deliver them for free. Even Amazon charges a minimal annual fee for the privilege of free delivery.
• Equipment: Similar mindset and habit as materials.
• Overhead: At this stage, many contractors are working from home and have converted the family van into their work vehicle, so they think that they don’t have any “real” overhead. How are you paying for the licensing, insurance, bonding, new computer, company phone line, website, fuel, etc.?
• Profit: At this stage, survival is the primary focus so if there is anything left at the end of the year, they are happy with their “profits”.

As defined in the Overhead and Profit infographic from the Restoration Industry Association (RIA), “Revenue is the income you earn by selling your products and services.”

Gross Profit = Sales Price – COGS (direct costs)

Scraping-by Mode (Adding Overhead)

The Bureau of Labor Statistics states estimates 20 percent of small businesses fail within the first year and 30 percent by the second year. Every entrepreneur, regardless of the industry they are in, knows that each year is an all-out battle. Assuming our new contractor makes it out of their first year, like many who have gone before them, they will start the year in the hole with a sizeable tax debt that they didn’t account for. For year two, they will have to pay for the prior year’s taxes and will be on a quarterly plan for the upcoming year’s taxes. While they may have not been thinking about overhead and profit as a business last year when they were trying to survive, they will be determined to learn their lessons and move forward in the coming years with the right habits.

The contractor now understands that charging $45 an hour did not get them closer to taking home $100,000 a year; it actually resulted in them making darn near (or likely less) what they did when they were an employee making $25 an hour. But, they can’t just go back into the field and start where they left off; they have a tax burden to fulfill from the prior year. So, they wise up and begin to understand that they must charge more than what they are paying themselves. Thankfully they now have some repeat business and the community is seeing that they are skilled at the services they offer, so they have some traction as well as better mindsets and habits.

The cost considerations at the scraping by stage:

• Labor: If the contractor wants to actually take home more than what they were making as an employee, they will need to charge more than what they charged for their services last year.
• Materials: The contractor begins to understand the pain of front-loading their costs and providing zero-interest loans, i.e. paying for materials with no markup and not charging for delivery; so they begin to charge additional labor and small percentage for material costs.
• Equipment: Similar mindset and habit as materials.
• Overhead: When that tax bill hit along with the renewals for licensing, insurance, and bonding, the contractor understood that there are real costs to running a business that are not directly applicable to the cost of labor or materials (indirect costs) and therefore they will need to begin charging something on top of their costs of goods sold (COGS) if they want to not go further into the hole while also filling in the one they currently have from the prior year.
• Profit: Unfortunately, the line between survival and scraping by is rather thin, because of the cost burden the contractor begins to understand they must charge something for overhead and/or indirect costs but they likely do not yet fully understand the necessity of profits.

The RIA’s Advocacy and Government Affairs (AGA) Pricing Committee states, “General overhead is what it costs to run the business (indirect costs), and is separate from the costs of goods sold (COGS aka direct costs).”

Net Profit = Gross Profit – General Overhead Expenses (Indirect Costs)

Fighting Chance Mode (Adding Profit) 

While it seems like it is too simplistic of a statement, the reality is that many entrepreneurs and contractors simply aren’t charging enough. In the early stages of a company, there is a fear that if the contractor raises their prices that they will lose customers. If a contractor doesn’t have enough work to survive, then they will have to do what they need to do. But, once there is enough work to at least scrape by, the contractor should begin to better understand their true costs of doing business (cover overhead) as well as experimenting with charging more for their services (build for vision).

Your family needs to eat (survival mode), but your business can’t survive if you don’t treat it like one (scraping by), so it’s important to remember that the business has to eat too (overhead), and if you want it to grow you must feed the vision, not just the needs (profits). 

Going back to the statistics from above, if our contractor is able to fight through to the end of their fifth year in business, they will be part of the 50/50 club. By year five, 50% of their competitors will have fallen off and by year 10, they will be in the 30% of entrepreneurs who make it to the decade mark. Contractors who start charging for O&P as a markup, something they add to their estimates (whether this is shown or embedded), need to understand the relationship between this practice and achieving the margins that their organization requires.

The cost considerations at the fighting chance stage:

• Labor, materials, and equipment the contractor better understands and is adapting their approach to properly charging for these items. See our upcoming articles in this series for means and methods to elevate your approach to these elements.
• Overhead: If the contractor changes their habits to account for their business needs, they will have a fighting chance.
• Profit: To have a fighting chance, the entrepreneur shifts their mindset and habits from O&P being what is leftover to it being a part of the vision, goals, and key performance metrics for the business. Their business and their vision need to be fed or it isn’t worth continuing down this road. 

Budgeted Gross Margin = General Overhead Costs As An Average + Net Profit Goals

Competing Mode (Adding Data) 

Our Declaration of Independence declares our nation as one where we are provided access to “Life, liberty, and the pursuit of happiness.” Nothing is guaranteed but the ground is fertile for those who will learn from their mistakes, collaborate with professionals who have shared values, and who will adapt each year to meet new challenges. The reader will notice the two final modes of profitability are fighting chance and competing. Success is not an end. Success is a state of being that requires constant nourishment. 

The cost considerations of Competing Mode:

• Labor, materials, and equipment|
  

Looking Ahead

I mentioned this is the first in a series of articles; upcoming features will include input from Ben Justesen, Anthony Nelson, and Ed Cross. Ben will help contractors to understand their numbers and incorporate them into their true labor burden (Labor + O&P). Anthony will share his vast experience in tracking material, equipment, and other cost realities to more accurately incorporate these items into your estimating process (Materials + O&P). Ed Cross has some exciting news to share from the frontlines of overhead and profit collection. All of these concepts will help contractors to determine the appropriate markups (what you add) to achieve their margin (what you make) goals.

If a contractor charges for some level of O&P they will have a fighting chance every year and will be ahead of many of their competitors. To move into this final mode of profitability the contractor should:

• Gather accurate performance data
• Wisely apply data to their vision and goals
• Grow their business with the right people and resources

For the new contractor, data does not have to be complicated to be useful. The contractor who wants to remain competitive isn’t competing with other contractors, rather they are competing with the law of entropy; wherein even if one organizes a system, it will trend towards disorder. Gathering, analyzing, and applying data to a business serves as the checks and balances for entrepreneurs who are developing their professional skills and adapting their business year over year. As it relates to profitability some of these relevant data points may include:

• Which revenue sources have been the most productive?
• Which regions have shown the most growth?
• Which business partners (carriers) have been the most profitable?

A contractor may believe that a certain partner has been profitable but perhaps there is a trend where that is diminishing over the last quarter. This would only be recognized with some form of data capture and digging into that reality can help uncover whether the issue is internal or external. Feeding the business is key to laying a foundation, but growing the business requires those in a position of leadership to continue to develop their mindsets and habits to meet the challenges of each new phase.

If the reader has found this information to be helpful, the contributors have been volunteering together for the RIA as they all see the benefit in contractors working together to connect, collaborate, and conquer our shared challenges. Please consider joining the RIA, contributing to the AGA, and meeting us all in person at the next annual convention.