Making Sausage

Part 8 of a Series on Benchmarking

Last month we talked about the first three steps in setting a gross profit target. Now comes the part where we run the numbers from steps one, two and three through the grinder. Here is the recipe:

• Take annual operating expenses.
• Add owner's compensation package in dollars.
• Add net profit target in dollars.
  Combined, these will give you your total gross profit dollar target per year. Determine sales dollars producible in the same time frame.
• Divide producible sales dollars by gross profit dollar target. This will give you your target gross profit percentage.
• Determine the labor, subcontractor and materials markup you will need to hit the gross profit percentage target. (See "Praying or Planning for Profit?" August 2003). To do so, simply divide the target gross profit percentage by 1 minus the target gross profit percentage.

Neither your markup nor your gross profit margin is a standard industry percentage. Both are a function of what items you assign to overhead, how much labor burden sits in overhead versus cost of goods sold, and how much slippage is inherent in your firm's produced margin results. (See "The Case of the Boisterous Bar Braggart," April 2003, and "Pardon Me, Is That Your Slip Showing?" October 2003.)

But I assume no one wakes up each morning with the mantra "I sure hope to be average today!" Here are recommendations to put you in the top 25 percent.

Place all labor burden in cost of goods sold. Include all bonuses and pension costs in overhead. Target a 37 percent gross profit margin with net profit (before owner's compensation) of more than 20 percent. That requires a 58.73 percent markup. Given the nature of the remodeling beast and the likelihood of slippage, I would budget for 40 percent gross profit at 66.7 percent markup to get a produced gross profit of 37 percent.

The key is the owner's dollar needs for net profit and compensation package. A remodeler without offices, staff, health, life and disability insurances can achieve this with as little as 28 percent margin and 38.9 percent markup. Companies doing more than $3 million in annual volume might achieve a 10 percent net profit target with even lower markup and margin by subcontracting all work instead of hiring field staff (which often results in greater slippage) and/or choosing a compensation figure that is less than 10 percent of revenue.

Budgeting: the basis for profit

Let's go through the steps of creating a budget that has legs; predicts a pricing model; forces decisions based on financial impact as well as production impact; and can be tracked quarterly, or better still, monthly.

It should be done with good, better and best projections. That way, if the year goes better than planned, you already have chosen the programs, purchases, marketing ideas, hiring, salary and other portions of the business plan that can be added to the to-do list. If the year is going poorly, you already have a written priority list of the programs, expenses and capital purchases not to make. These decisions have not been made under emotional duress and financial considerations have already been played out.

Overhead Budget: Start with your 2004 results. Add to items where you already know increases will be larger than inflation: liability, workers' comp, health insurance and utilities.

Next, take a look at the other 10 to 40 things you track and see what would make for the best use of business dollars. You may want to add dollars for raises, a part-time bookkeeper, a Web site or employee education. Attending a trade show or joining a networking group costs more than the price of admission; hotel, food and time away from producing income all need to be factored into these decisions.

When you are comfortable that the numbers reflect the personal and business goals you have chosen for this year, determine if the expenses will apply toward the whole year or only part of it. That way, when you use this budget as a basis for the next year, it will reflect accurate annualized expenses.

Labor Burden Budget: Your actual cost for any hour of labor is often 60 percent more than the nominal hourly rate. You will never make gross profit targets if you are under-accounting for labor costs. Don't forget to add the cost of Social Security and Medicare taxes (FICA); state and federal unemployment taxes (FUTA and SUTA); workers' comp, general liability and health insurance; paid and unpaid vacation, holiday, personal and sick days; training and education; tool and gas allowances; and picnics, parties and gifts.

You can budget for all your costs of employment by applying a labor burden multiplier to every hour charged to a job. Look at billable hours, not paid hours. They are the only ones that can produce income, regardless of the value of hours invested in other activities. QuickBooks and all industry-specific accounting packages allow for this function, so use it.

Profit Budget: The industry standard for net profit is usually 10 percent of revenue. I agree. However, as a company matures, the owner should look for ways to build assets that will be a retirement vehicle rather than show net profit. I suggest six months of overhead expense coverage in retained earnings before you let up on the profit goals.

When we budget revenue, we can confirm our net profit dollar goal is attainable. If you have balloon loans or looming capital purchases, if the long-term trend for your specialty is falling, or if you are positioning the company for sale, bonding, or a loan package, you will have extra work to make sure that net profit remains a priority.

Owner's Compensation Budget: The industry standard is 10 percent of sales, including benefits. Another possible benchmark is a minimum of $52,000, or 10 percent more than your highest-paid employee. In years when you have sufficient retained earnings, you can shift up to 15 percent for the owner and down to 5 percent for net profit. The short answer is, you should have 20 percent of revenues to prioritize between the owner's pay and profit for the business entity. This thinking is a necessity whether you are a sole proprietor or a C-corporation employee.

Sales Budget: Start with last year's produced revenue, not sales. Production is the lynchpin in collecting the money, and it is the gauge most helpful in predicting next year.

Other factors you need to assess are sales and production per employee. We track sales per sales hour (we have no full-time sales employees). We look at production per field employee to see if we need to hire to reach target revenue. If you use lead carpenters, you need to track sales per lead as well. Filling a lead's plate too full is a disaster for both the client and the firm. Lastly, the sales per management employee tells us if we have the administrative support to keep up with job costing, contracts, change orders, payroll and accounts payable. These things must be done in a timely fashion, or we are flying blind.

Pay close attention to the biannual forecasts of NAHB chief economist David Seiders, who reports on materials costs and availability and demand for services and products. Check your instincts against the Remodeling Market Index and Housing Market Index.

Lastly, remember that more companies die during growth periods than in hard times. Growth without proper cash flow is the kiss of death. You should not grow more than 10 times your working capital or more than 12 times your working capital ratio (See "Are You Dying to Grow?" January 2005).

Put those numbers into a spreadsheet that can track budget expenses and income by quarter or month. Next to this year's budget figures, have one column showing last year's numbers, a second for next year's, a third column for each month or quarter's actual performance, and a fourth column showing the variance between the budget and actual.

Reality Checks

Now, what margin and markup are required for this plan to work? If we take overhead with owner's compensation, add a profit goal in dollars, then divide it into the proposed sales dollars, we get the gross margin needed to make the plan work. If owner's comp is $100,000 and profit is $100,000 and we have overhead of $160,000, we have a total of $360,000 to cover in gross margin dollars. If we have predicted $1.2 million in sales, then gross margin needed is 30 percent. To determine markup, divide 0.3 by 1 minus 0.3, or 0.7. Your markup is 42.86 percent.

We're not done yet. Average slippage — the difference between budgeted gross profit margin and produced margin — in our industry is more than 5 percent. The primary cause of slippage is poor estimating skills caused by lack of, or poorly performed, job costing. Ideally you want to find and eliminate the root cause of slippage. In the meantime, the easiest thing to do is to add 5 percent to margin and redo the markup math.

If you can account for all your costs, pass most through to your clients in the form of direct costs, control overhead expenses, reach or exceed target revenues and sell at the markups that you know you need, you will be both successful and happy in this business.

Good luck and happy planning!