Jim Huston Certified Professional Landscape Estimator, J.R. Huston Enterprises, Inc.

Margins and Mark-ups: What’s the Difference?

Misconceptions, faults and outright mathematical errors exist in the minds of many contractors when it comes to using margins and markups in their estimating systems. Conventional wisdom can get the contractor into serious trouble if he does not understand the limitations of both when used in the bidding process.

Historical Definitions

A markup is commonly used in a bidding situation as a factor in the form of a percent or decimal multiplied by a direct cost or combination of direct costs. For instance, all direct costs (materials, sales tax, direct labor and labor burden, equipment and subcontractors) might be increased by 25% to achieve the final selling price for a job. Mathematically it plays out as follows:

$10,000 (total direct costs, TDC for short) X 1.25 (or 125%) = $12,500

The markup applied to all direct costs is 25%. So the thinking goes that if you desire a 25% gross profit margin (GPM) for your business at the end of the year, mark up all of your direct bid costs by 25%.

A margin, on the other hand, is slightly different. To achieve a 25% margin, the mathematical formula differs slightly from that for the markup. We divide the total costs by 1 minus the desired margin:

$10,000 (TDC) / (1-.25) = $10,000/.75 = $13,333

Notice the difference in the final price for the two examples. The second has actually achieved a 25% margin on top of all costs (if you divide the margin amount by the price, you get .25 or 25%).

$3,333/13,333 = .25 or 25%

However, use the first example and divide the markup amount by the price…and you lose 5%.

$2,500/12,500 = .2 or 20%.

The lesson learned? A 25% markup translates into a true 20% margin.

So What’s the Big Difference?

Many contractors mark up costs by some factor or combination or factors without realizing that mathematically they are going to lose margin points along the way. If you are marking up your direct costs by 25% to achieve your final price, you automatically lose 5%. Even a 10% markup loses you 1% on bids.

Most of today’s markets will allow you to get at least a true margin of 25% on your bids. To achieve a true 25% margin using the mark-up method, you would have to mark up the TDC by over 33%. Again, this may not seem like much but if your sales are $500,000 per year over a career of 25 years, a 1% margin increase will get you an additional $125,000 of net profit…which could go into your retirement account.

Common Misconceptions (Back to Basics)

Applying sales tax to material costs; workers’ compensation insurance rates to labor costs; FICA, FUTA and SUTA rates to labor costs; are all examples of markups properly applied to costs in the bidding process. For example, a materials sales tax rate of 6% is a markup. Every $100 of material costs is marked up $6 for sales tax.

The erroneous use of markups and margins in the bidding process generally occurs in two areas. The first is in the recovery of indirect G&A overhead costs. The second involves achieving a desired GPM on the company profit and loss statement at the end of the year.

Conclusion

Markups and margins are different as commonly used in the construction and service industry. Mathematical misconceptions ranging from simple quirks in arithmetic to faulty assumptions in complex indirect G&A overhead recovery cost formulas can cause the uninitiated estimator to overstate or understate important cost components in a bid. Accurate cost estimating is the real issue.

Once properly understood and used, markups and margins can provide useful tools for the contractor to not only analyze individual bids, but they can also help analyze markets and market trends. These tools can not only help assure that today’s jobs are bid accurately and competitively, they can help ensure that the contractor will be around to bid on tomorrow’s jobs as well.

Jim Huston is president of J.R. Huston Enterprises, Inc., which specializes in construction and services management consulting to the Green Industry. He holds the distinction of being one of only two Certified Professional Landscape Estimators in the world.