Are You Budgeting for ROI? Insights from FMI Quarterly
Remaining competitive while still generating an overall profit is an issue with which many construction companies struggle. In the article “Pricing for Profit,” featured in the most recent FMI Quarterly, authors Tyler Pare and Ken Roper address different aspects owners may consider when pricing work for a bid. A quick synopsis of their findings is provided below:
In construction, it is easy to accurately allocate direct costs to a job, but allocating overhead resources can be more complex. Companies not properly budgeting for overhead costs can inadvertently cause a job to lose profitability. If the job is profitable, it could mean the job was budgeted for properly, however there is a possibility that the job was budgeted too high, putting the company at the risk of losing business compared to its competition. If the job is unprofitable, it can put the owners in a disadvantageous state of losing equity. In reality, not every job is profitable, but the question becomes: how do you make sure you are running a business that is building a return on your investment as an owner?
Pare and Roper suggest that contractors should be expecting 25% to 40% returns on their investments. This means businesses should receive income at around 25% to 40% of their net worth. If a company is not earning income at this rate, it should be looking at raising contract prices. But if you cannot raise prices to the appropriate levels and still win work, what can you do to change as a business? Are projects being mismanaged? Are overheads too high and need to be reduced? Do you need to adjust strategy?
Perhaps your first question should be whether or not you are using the proper analytics to measure profitability? Some companies do a markup on costs in order to price contracts. This markup represents the ratio of contribution margin to direct costs. Meanwhile, others use margin which is the ratio of contribution margin to revenue. For example, if companies are only using a 15% markup on direct costs, then they are never getting a return on investment on their overhead costs. From the beginning, companies would have a lower than 15% gross margin, which is well below the suggested 25% to 40% return on investment.
A popular way to measure gross margins has become the dual-overhead rate. This rate focuses on the fact that labor is the largest section of overhead. The dual-overhead rate uses two different markup percentages: one for materials and subcontractors and one for labor. This allows for a lower markup on materials and a higher markup on labor costs which proves to be a more accurate method. Since overhead can have a drastic impact on a job’s profitability, it is important to properly allocate and account for it. If certain costs, such as bidding costs are sometimes allocated directly to a job and other times allocated into overhead, this leads to inconsistency and potential duplication of costs which in turn, could result in lower gross margins. As companies evaluate their rates and profitability, reviewing historical allocations and other information can help to shape future decisions.
In conclusion, Pare and Roper suggest that owners should be evaluating how budgeting and forecasting impacts their overhead expenses. By doing so, it will aid in the bidding process and hopefully lead to a more profitable future.
Contact Us If you would like to read Pare and Roper’s article in the FMI Quarterly, you can download a copy of the publication here. If you have questions on remaining profitable, the dual-overhead rate or any other questions, please call us at 513-241-8313 or click here to request a call from us. We hope to speak with you soon!