Most contractors check their books at the end of the year and find themselves wondering:
“Where did my profit go?”
There’s often more than one answer to that question, but this question brings us to one very common answer: Whoever is pricing the work doesn’t understand the difference between a profit markup and a profit margin.
Do you understand the difference? Here’s a quick test:
What’s 15% profit on service that costs $100?
Did you answer $115? If so, keep reading! This is one lesson that will really help your bottom line.
To get a 15% profit margin on $100, you need to add more than $15. How so? Well let’s look at the math. The formula for a profit margin is this:
(Price – Cost) divided by the Price.
Looking at our example, the price is $115 and the cost is $100. So we do ($115 – $100), which equals $15 and then divide by the price, which was $115. $15 divided by $115 = 13.04%. That means that, at $115, you are only earning a 13% profit margin! Your formula for a 15% profit just cost you almost 2 full percent.
How did that happen?
The formula for a profit margin is PRICE – COST divided by PRICE. To calculate their profit margin, most people take the cost of the item and add the % profit they want to earn. In the case we just looked at, 15% of the cost ($100) is $15… so we added that to the cost ($100) to arrive at a price of $115. But the formula for profit margin is (PRICE – COST) divided by the PRICE (not the cost). You need to divide by the price to find the margin. $15 is 15% of the cost ($100), but it’s only 13% of the price ($115) and that’s how you ended up with an actual profit margin of 13.04%.
When you add 15% of the cost to arrive at a price, that’s called a profit markup. It is an accepted method for calculating a profit, but it’s not the profit you think you earned and it’s not the net profit margin your accountant will hand you back at the end of the year. Repeat the “markup mistake” in your pricing all year, and you’ll find your bottom line is short of what you expected. When your accountant calculates your net profit margin, they take your sales, minus your costs, and divide by your sales again. They use a profit margin.
How do I calculate a profit margin to price my work?
It’s easy to calculate a profit margin, you just use a different formula. The formula for a profit margin looks like this:
COST divided by (1 minus desired PROFIT MARGIN). Remember that your profit margin should be expressed as a decimal.
Continuing our example, to find a 15% profit margin on $100, the formula would look like this.
- $100 divided by (1 – .15) (where .15 is a 15% profit margin)
- (1 – .15) = .85
- $100 divided by .85 = $117.65
To make a 15% profit on $100, you need to price the service at $117.65. Let’s make sure this works:
- PROFIT MARGIN = (PRICE – COST) divided by PRICE
- ($117.65 minus $100) = $17.65
- $17.65 divided by $117.65 = .15
- .15 = 15% profit margin
So now you know the important difference between a profit margin and a profit markup. Better yet, you might have just found some profit that’s been “missing” from your business, and you can fix it by just updating your math. Price your work with a profit margin, and see if your bottom line doesn’t improve.
The Landscape Management Network, LMN, offers tools and education to landscape and green industry contractors to help build and develop more sustainable, more profitable businesses. To find out how LMN can help you build a pricing system for your company and improve operations and profit, check out the website at www.landscapemanagementnetwork.com.
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