Decreasing Profit Margins in Construction & What You Can Do to Protect Yours
Posted February 11th, 2021
Low profit margins in construction have been an issue for decades, and even as we climb back toward normalcy following the shutdowns caused by the coronavirus, there are few signs if any that profit margins will increase with increased demand. In fact, most contractors seem to expect the opposite. According to the Associated Builders and Contractors Confidence Report, contractors expect sales to grow over the next six months. Over half of the contractors surveyed said they expected some level of growth. Ironically, only about 30% expected profit margins to increase, while 35% expect them to drop.
Why are construction profit margins so low, and continuing to shrink? And, perhaps more important, what can you as construction business owner, do to protect your margins?
Why Are Construction Profit Margins Low
There are several economic reasons for low construction profit margins. The highly-fragmented nature of construction naturally spreads money thin; potential profit margins cover several different trades all working on the same project. There has also been historical cost and labor inflations, eating up profit on every project. There are also higher material costs right now.
The rise of remote work options post-pandemic has had an impact on commercial construction. There is less demand for large, urban headquarters, less parking lots, and less development around these work hubs. The decline in projects across the industry resulted in fiercer competition, driving prices (and thus, potential profit) lower.
Finally, contractors have played a role in their own low margins. Contractors regularly bid on low-profit jobs, hoping that their performance will win them the next contract at a better margin.
Pause right there. Think that through. If you bid and win a job with a 15% gross margin, and the project requires 10% retainage, then you only have a 5% profit margin to operate the job. Yes, the real margin is 15% (and not 5%), BUT what good is that profit for your business right now if it is tied up in retainage and you won’t receive it till the entire project is over?
Will a 5% positive cash flow even be enough to support your team throughout the project so they actually can deliver their best performance?
Chances are the answer is NO. So, let’s focus on getting you the profit margin you actually need in order to perform.
Tips to Increase Construction Profit Margins
Know Your Actual Profit Margin
Let’s start with the basics: you need a system to accurately calculate your expected profit margins before you can start to improve them. You also need to know which types of jobs resulted in high profit margins, and which nibbled away your profit to crumbs.
One of the key data points in estimating profit margin is overhead, which leads us to Tip #2.
Adjust for Actual Overhead in the Bid
This is probably one of the simplest tips to increase your profit margin. Contractors who guess at their overhead costs are operating at a disadvantage right from the start. A 2019 study from the Journal of Building Engineering revealed that 44% of the 2700 projects examined actually experienced a loss after adjusting for overhead. This is just not acceptable and should not happen. Overhead costs (insurance, rent, utilities, staff salaries, etc…)are all real costs just like labor and materials – they should never be left out or a “best guess.”
Hire a CPA or Controller or BOTH
Do you know your company’s Gross Profit, Operating Profit, Pre-tax Profit, and Net Profit? Do you have a breakdown of historical job costs and margins? Do you currently run an AR Aging Report to know which customers you absolutely have to track down and get their accounts squared? Do you have a daily cash report that shows you precisely how much cash you have and what it needs to be used for? A CPA can help with ALL of that.
In construction, you should also have a CPA that knows construction – there are plenty of them out there and using one that knows your industry, works with customers already in the space, and how to help you manage through it is critical.
Bid More, Bid Smarter
While working jobs just to have revenue coming in at the expense of profitability is a bad idea, if you want to consistently earn a certain profit margin on every job you are going to have bid more jobs. Utilizing a service like ConstructConnect can give you access to more jobs in your area, as well as estimating tools and streamlined bidding dashboards.
Bidding more jobs has an additional cost associated, and a service like ConstructConnect can also help you lower your cost to bid, which can also help increase your profit margin.
Work from a Place of Abundance
This is a mindset shift, not a tactical strategy. Earlier in this article, we asked if a 5% profit margin was enough to support your team throughout a project. Our CEO calls this “working from a place of scarcity.” When you work from a place of scarcity, you feel stress. Your team feels stress. The GC probably feels your stress, too. You can’t truly do you best work, because you are operating at a disadvantage.
Here’s the shift: Operate from a place of abundance. Know the baseline profit margin you MUST earn in order to complete a project the RIGHT way. Then, bid on more of those jobs. Don’t be afraid to have a higher price than competitors. You may not win them all, and that is okay. You will be focused on performance, not price, and the results will show in your work. And over time as you execute those jobs and finish them those same results will show up in your bank account and your stress level!
Make Performance Your One KPI
Nothing should matter as much as performance. To create greater accountability within your team, link financial incentives to project goals. Empower your team leaders to own the performance on the entire PROJECT, spotting potential efficiencies as well future issues in advance, and bringing them to the GC. Not only will the project go more smoothly, but you will be creating a legacy of trust, accountability, and great work. That reputation alone will bring you more business than any other single thing you do.
Know Your Financing Options
Most subcontractors struggle to cover the upfront costs associated with new work. Before you jump on a Merchant Cash Advance or take out a personal loan, research all of your available options for financing. This research should take place BEFORE you win the contract, so you can absorb the cost of financing into your bid and preserve your profit margin. Not all money is the same and not all costs are the same – structure of the loan, the amount, how you use it and what you can use it on all matter!
Construction profit margins are notoriously low compared to other industries, and experts suggest they are going to drop lower before they get better. Savvy contractors will weather the downturn by knowing what they absolutely have to make on each job in order to survive, and then ensuring they get it every time.
Go get paid.