I just recently re-read an article I had read a while back entitled How Much Profit Is Enough? by George Hedley of Hard Hat Presentations and it got me re-thinking on the concept of Net Profit.
George Hedley owns a $75 million construction and development company and Hardhat Presentations. He speaks to companies on building profitable businesses, leadership, and loyal customers. He holds 3-day in-depth “Profit-Builder Circles” open to construction company owners in an interactive roundtable format every 3 months.
I’ve talked with a bunch of contractors over the last few years who when talking about Net Profit cite either that the Remodeler’s Cost of Doing Business Study that shows remodeler’s typically reported Net Income earnings (net profits) falls in the range of 6.2% to 8.4% so that’s what they target. Interestingly the study I have at hand (1997) says “The average net profit reported by all of the remodelers responding to the survey was 6.8% of sales” but then goes on to say that “The net profit of the most profitable firms in the study (the top 25 percent of respondents ranked by profitability) was 15.6 percent…“. I then ask myself why are so many contractors targeting the average rather than the most profitable performance level?
Michael Stone on pg. 186 of his book Markup & Profit: A Contractor’s Guide says “You should be making a minimum of 8 percent net profit” but there’s really no reasoning or discussion on it beyond that sentence. Ellen Rohr in her book How Much Should I Charge?: Pricing Basics for Making Money Doing What You Love doesn’t really make any recommendations but does use a pretax net profit target of 20% in one of the contractor examples she profiles. In the PROOF manual on markup and pricing, “How To Survive and Prosper In The Contracting Market”, on page 66 Irv Chassen writes “It is not PROOF’s purpose to recommend or suggest the rate of profit markup…” although in the contractor examples he profiles he often uses 8%.
Still it seems no one offers any reasoning or arguments as to what’s a good number to use.
However just the other day when I re-read that article How Much Profit Is Enough? he presents some real reasoning as to how to think about Net Profit. First off he writes about a really good point when with “The goal in business is NOT to stay in business. The goal of business is to ALWAYS MAKE A PROFIT” that I don’t think a lot of contractors get. How many contractors do we all know who’s businesses really aren’t businesses at all but just their vehicle to give themselves a job.
But then he goes on to say:
—“If asked to invest $100,000 in a friend’s new start-up business, what return would you want? 10%, 15%, 25%, 50% or More? After considering all the risks, I would never invest in a new business that didn’t offer at least a guaranteed 15% to 25% return on equity or capital. Likewise, the minimum pre-tax net profit goal for your company should be 15% to 25% return on equity (or higher).”—
Return on equity, that’s a different way of looking at it that I haven’t heard anyone else say or write about that I can recall. Equity being defined as the net worth of a company or what kind of money the owner has invested in getting the business up and rolling makes it makes a lot of sense to me to figure Net Profit as a return on that investment.
Using his model and lets say you were a start up and had invested $ 100,000 in getting things rolling by buying trucks equipment and setting up a payroll reserve you would then want a $20,000 return on that investment (in addition to paying yourself a salary or wage). The for example if you were using a Capacity Based Markup strategy you would then take that $20,000 goal and divide it by the number of billable hours you expected to generate in a year and add that to any markup figure you had already figured on for covering your overhead.
If you been in business for a while and your company’s net worth is $300,000 like in his example you would want to get a $60,000 return on that investment.
Those dollar figures you could then reverse engineer into a percentage of sales and that 20% Return on Equity might then appear anywhere within a range of the range of 6% to 20% of sales in residntial remodeling or even the 2% that typical commercial contractors getting. Does that make sense? How’s that sound? I do think that’s a better more rational way of looking at Net Profit than just plugging in some arbitrary percentage just because someone says that’s what you should use.
Other George Hedley Articles on “Net Profit”: