There is a saying that failing to plan is planning to fail. It is truer than you want to believe. Unless you are exploring Mars, there is information that you can and should use to get from Point A to Point B. The start of any successful business year is to make an intelligent guess at what the end of the year will look like — starting with the end in mind.
That said, let’s go through the possible steps in 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 to keep score month by month.
The start is the owner’s compensation that you would like to have, or at the very least, what you need to have. Here your personal needs and goals will drive how much money has to be used to satisfy owner’s compensation and benefits. All goals and desires will have financial affect, and you need to bring those costs to the company to help in making them realistic.
All goals should be SMART:
- Action Oriented
- Time Sensitive
A goal that can’t be looked at in these terms is merely a wish. A plan to increase sales can be made merely by letting inflation take hold. A plan to “increase residential remodeling sales revenues by five percent compounded over the next three years by increasing prices and without adding staff” is a realistic goal. It has a time frame and is specific, action-oriented, measurable and, with proper planning, attainable.
Only with a goal like this in mind can a working budget be established. Think of the budget as an opportunity to anticipate your best year ever while having a plan in place for adjustments if the financial picture sours. With a sound budget, if the year is going better than planned you already will have chosen the programs, purchases, marketing, hiring, salary and other pieces of your business plan that can be added “To Do.” If the year is going poorly, you have a written list of the programs, expenses, and employees to be cut, and capital purchases not to be made. With a predictable budget reaction plan, you have made the hard decisions on paper outside of the emotionally charged climate at the time of the actual cutbacks (or increases).
To judge whether you are having a good year, a year better than last or your best year ever, you can measure both volume and gross profit margin percent — two gauges that can predict the year’s-end outcome of your labors accurately.
With IRS Section 179 depreciation write-offs, it is easy to play the tax-and-profit game on capital purchases right up until you actually have to pay your taxes. Other tax issues and timing need to play out before year end. These possible scenarios of selling for a loss or gain; larger pension contributions or none at all; not sending out bills or collecting checks are all in play to help that plan made the previous year play out close to the playbill on Dec. 31.
Step 1: Know What’s in Overhead
Start with the results from your most recent year, whether it is your tax form, your QuickBooks, CheckWriter or industry-specific accounting package. History is a great basis to make wise decisions. Add to items where you already know increases will be larger than inflation such as: liability insurance, workers’ compensation, health insurance, heat and electric utilities and add those that you have some control over but want to increase. Those might be a Web presence, new job signs, new logo and collateral materials, a part-time bookkeeper, a salary for your spouse, raises, increased benefits or other items.
Next, take a look at the other chart of account categories you track and see what would make for the best use of business dollars. Education, for example, might include attending the International Builders’ Show (IBS) and other NAHB-sponsored meetings; joining a 20 Club; or working toward your Certified Graduate Builder or Remodeler (CGB or CGR) or Graduate Master Builder or Remodeler (GMB or GMR) designation through the University of Housing. Registration costs, lodging, food and time away from producing income all need to be factored into these decisions.
When you are comfortable with the path your expenses are taking you on and believe the numbers reflect both your personal and business goals, you can decide whether to cost your expenses all this year or partially this year and the rest next year. The year in which you plan to expense items needs to be reflected in this year’s budget so annualized expenses will be reflected accurately.
Step 2: Budget With Profit in Mind
The industry standard for profit is usually 10 percent of revenue, and I agree that that is a noble target, but as a company matures, it should be finding more ways to build assets that might be a retirement vehicle for the owner, rather than focusing on showing a net profit.
I like to see six months of overhead covered in retained earnings before letting up on the profit goals. You can do the math to find a break-even point in terms of dollars more readily than coming up with a percentage. I will show you how to do both calculations, but a fixed dollar amount is easier to work with. As we determine revenue in Step 4, we can confirm whether our net profit dollar goal is legitimate or attainable.
Don’t just Plan for a break-even year; one will come all too often without planning for it. Aim high because gravity will pull your arrow lower than the bull’s eye for which you were aiming. If you have balloon payments or capital purchases looming, if the long-term trend for your specialty is falling or if you are posturing for sale, bonding or a loan package, you will have extra work to make sure that net profit remains a business priority.
Step 3: Determine Your Compensation
The industry standard is 10 percent of sales, including benefits, for the owner. Another benchmark would be a minimum of $52,000 for each owner, or 10 percent more than your highest paid employee (in annual compensation for fellow salaried employees, or 10 percent above the hourly rate for hourly employees).
If using an hourly rate, you multiply the sum by the number of hours you work, which probably will end up being 20 percent more hours than your full-time employees work. In years when you have sufficient retained earnings, you can use 15 percent as the multiplier for salary and show five percent net profit. In any case, you should have as much as 20 percent of revenues available to choose between pay for yourself and profit for the business entity. This applies whether you are a sole proprietor, S Corp member or a C Corp employee.
Step 4: Make Sales Predictions Based on Actual Revenue
Start with last year’s produced revenue, rather than sales. Production is the linchpin in collecting the money, and it is the gauge most helpful in predicting next year. You also need to assess sales per employee. In our business, we track sales per salesperson, per sales per hour or as a % of a full year, referred to as per full-time-equivalent employees, because we have no full timers. We look at production per field employee to see if we need to hire additional staff to get to that increased 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, regardless of the quality of the subcontractors that might fill in for needed production hours.
The sales-per-management-employee tells us if we have the office support to keep up with the paperwork, job costing, contract and change-order writing, payroll and accounts payable work. If the paperwork is not done in a timely fashion and reports are not generated for decision-making, we are flying blind, perhaps even living “La Vida Loca” on our checkbook balance.
Pay attention to larger trends. Pay close attention NAHB chief economist Dave Seiders, who reports on materials costs and availability, demand for services and products (including a separate breakdown for remodeling), the cost of money, inflation and other trends that affect the business of building. You also can use the Remodeling Market Index (RMI) and Housing Market Index (HMI) to see if your feelings are backed up by your peers who participate in these periodic surveys.
Last, remember that more companies die from indigestion than starvation — more die during periods of growth than in hard times. Growth without attention to cash flow or access to funding is the proverbial kiss of death. You should not grow more than 10 times your working capital (current assets – current liabilities) or more than 12 times your working capital ratio (working capital ÷ sales).
Working capital determines growth projections. For example, a company with $100,000 of current assets and $123,000 current liabilities shouldn’t plan to grow at all since it is, at least in the short term, bankrupt. If the numbers are reversed, then we have working capital of $23,000. If sales are $1 million, we have a working capital percentage of 23,000 ÷ 1,000,000 or 2.3 percent. Using this information, the maximum safe growth for this company is 10 x 23,000 or $230,000, or, using a percentage, 12 x 0.023 = 0.0276, 27.6 percent, or $276,000. Using the smaller number — the more conservative one — would be appropriate.
Four columns of timely data. We now put those numbers into a spreadsheet that can track expenses, not by the year, but by the month, so keeping score will be timelier. We will have four columns: one for last year’s historical results, one for the coming year’s budget, one for each month’s actual expenses compared with the budget, and one for the variance (in dollars, a percentage or both), so you can see if the difference is material or marginal.
Time for a reality check. What margin and markup are required for this plan to be workable? If we take overhead with owner’s compensation, add a profit goal in dollars, and divide the total into the proposed sales level, we arrive at a gross margin needed to make the plan work. Example: If owner’s compensation is 10 percent or $100,000 and profit is 10 percent or $100,000 and we have overhead of $160,000, we have $360,000 to cover. If we have predicted $1.2 million in sales, then the gross margin needed is $360,000 ÷ $1,200,000 or 30 percent. To determine mark up, divide margin by 1 minus the margin, or 0.30 ÷ (1 – 0.30) or 0.30 ÷ 0.70, which equals 42.86 percent. Or, for mark-up multiplier, you would use the following equation: 1 ÷ (1 – margin) or 1 ÷ 0.7, which equals 1.4286.
To use profit percentage to get a mark-up, you need to figure overhead and owner’s comp together to get a break-even margin, and then add 0.10 to the result to get a target gross profit margin including a 10 percent net profit. Thus, overhead and owner’s comp as a percentage of sales is $260,000 ÷ $1,200,000 or 21.666 percent. Add the 10 percent target margin and you get 31.666 gross margin needed. Markup for this is 0.3167 ÷ 0.6833 or 46.35, or 1 ÷ 0.6833 or a markup multiplier of 1.4635.
Wait. You need to account for slippage! As you can see, any budget can be assembled and a pricing model calculated before the first nail is driven. But we are not done yet. Each company has a silent partner in business, commonly called slippage. The average in our industry is more than five percent, so this partner routinely takes home $50,000. You need to add this difference between theoretical margin and produced margin. The causes of slippage are many and varied, but the primary one is poor estimating skills caused by lack of — or poorly performed — job costing. You end up never knowing where you are failing, so you have institutionalized this slippage, which is a bad situation. The easiest thing to do would be to simply add five percent to gross profit and redo the markup math. That would be a good start, but finding the root cause and maybe the root person (maybe you are the root) is the proper response.
Benchmarking, writing down all these major targets (and others), communicating with your staff to have them on board with profit goals, overhead control, gross profit slippage, and employee efficiency are the keys to success and safe growth. For more information on this topic, you can read my series on benchmarking in Professional Remodeler (follow this link to learn how to get a free subscription), or go to Housingzone.com for a markup calculator.
Step 5: Don’t Underestimate the Cost of Labor
The last area of budgeting is for labor costs. Your actual cost of any hour of labor is often 60 percent more than the nominal hourly rate and in some cases almost 100 percent greater. You will never make gross profit targets if you are under-accounting for labor costs. If you look at a spreadsheet on labor burden, you can see that adding Federal Insurance Contributions Act (FICA); Federal Unemployment Tax Act (FUTA); State Unemployment Tax Act (SUTA); worker’s compensation; general liability insurance; health insurance; vacation, holiday, personal and sick time; training and education; tool and gas allowances; and picnics, parties and gifts, you may find the costs of labor may be more than you are charging in your pricing models.
After you determine the total costs, you need to look at billable hours, rather than paid hours. They are the only ones that can produce income, regardless of the value of benefits mentioned above or hours invested in other activities. When you price your jobs, budget for all of your costs of employment — regardless of the week they are incurred — by using a labor burden multiplier for every hour charged to jobs. QuickBooks and all industry-specific accounting packages allow for this; use them.
Find your break-even point. Important targets like break-even are simply a matter of doing the math. Break-even is the point at which you just cover overhead with gross profit margin (with no net profit). To calculate break-even, divide the gross profit margin produced into the overhead before profit. In the previous example, if we had a 33.33 percent gross profit using a 50 percent markup and $260,000 of overhead, we break even at $780,000 or ($260,000 ÷ 0.333). All revenue after that point is providing a 33 percent gross profit and 33 percent net profit.
If you know what markup and slippage you are experiencing, you can calculate the target revenue you need for the year. Simply take overhead and profit, and divide by the corresponding margin created by that markup added to your percentage of slippage. Working backward, you would divide markup percentage by one plus the markup percentage. In our example above, with 50 percent markup, the equation would look like this: 0.50 ÷ (1 + .50) or 0.5 ÷ 1.5 = 0.3333 margin theoretically produced by this markup. Add back your historical slippage to that 33 percent theoretical margin and redo the markup math. Five percent slippage added to 33 percent margin makes a 38 percent target and a 61 percent markup, 1 ÷ (1 – 0.38) or 0.6129. Not accounting for slippage would be some people’s definition of insanity: doing the same thing over and over and expecting a different result.
If you want to add to your profit, you have choices:
- Increase sales
- Decrease overhead
- Increase margins
- Do all of the above
If you add volume, but overhead increases at the same rate or greater, you will make less money. More volume adds challenges that decrease efficiency of the office, field, sales, and the owner’s judgment and sharpness. So, I will leave you with a final warning: There is only one Wal-Mart. If you are not making money at your present volume, you are unlikely to “pull it all together” at a greater volume. Instead, you will merely go out of business faster!
Finally, if you want to buy a truck, add to your office, hire a salesperson, purchase software and hardware or otherwise invest to help maintain or grow your business, you can go back through the entire budget process or take a shortcut:
Divide the expected true cost by the produced margin and that will tell you the additional volume produced at that margin to cover the added expense. If other overhead items will go up as well, add them to the cost of the item and redo the math. Such items might include a cell phone, desk, calculator, license for another CAD seat, or auto allowance, in addition to the labor burden we discussed earlier. A salesperson at $50,000 could really end up being an investment of $85,000, when benefits and ancillary costs are taken into account. If you have a produced margin of 0.25 it would take $340,000 of additional volume to break even on your investment. If you are at 33 percent, it would take $255,000; at 20 percent margin, $425,000. Pay particular attention to this if you are growing, because most of your growth will fuel expenses and not net profit!
If you can account for all of your costs, pass most of them through to your clients in 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!
Alan Hanbury, CGR, CAPS, GMR, MBA, president of House of Hanbury Builders in Newington, Conn, has more than 40 years of experience in residential construction. He is a frequent instructor of many NAHB designation classes as well as a content provider, subject matter expert and reviewer of over eight of those classes. He has spoken at numerous industry shows and conferences on a variety of subjects relating to business management, and in 2012 he was named the NAHB Educator of the Year. Throughout his four decades of NAHB membership, Hanbury has been actively engaged within the Federation, chairing many committees and councils, including Education, Business Management and Information Technology, and Remodeler’s Board of Trustees.