Do Not Confuse Margin with Markup
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Many solar contractors use elaborate Microsoft Excel spreadsheets to create client proposals. They quote and track the cost per watt. But when they use the term cost, that amount typically represents the sales price, not the actual cost. Markup and margin percentage are two ways to keep track of both the cost and the price, but it is important not to confuse one with the other.
Margin versus Markup
While many solar contractors understand the difference between margin and markup, some small business owners continue to confuse the two numbers. I have spoken with many contractors who look at their profit and loss (P&L) statement and incorrectly interpret margin numbers, using these as their markup. The key is to remember that margin is always represented as a percentage of revenue; markup is always represented as a percentage of costs.
If you charge the customer $100 for something that costs you $65, then you make a $35 gross profit. That means you have $35 left over to pay your overhead, which hopefully leaves some profit. You determine the margin by dividing the gross profit ($35) by the sales ($100) to achieve 35%. Gross profit refers to dollars and gross margin refers to percentages. Therefore, in the above transaction, you earned a 35% gross margin.
You determine the markup by taking the gross profit ($35) and dividing it by the costs ($65) rather than the sales price. Therefore, you have a markup of 54%. You think: “Sure, I knew that!” The mistake comes when you use a margin number as a markup. In many cases, when you print out a P&L, it provides margin numbers only, representing all costs as a percentage of sales. If we sold 100 of the items above and created a P&L, it might look like Table 1.
Pitfalls of Using the Wrong Percentage
If you ask accountants what your overhead and profit are based on Table 1, they might just tell you that it is 25% and 10%, respectively. But these values are based on 35% of your sales rather than your costs. So what happens if you accidentally use the wrong value the next time you create a proposal?
If you have a job that includes the same $65 piece of equipment, you might be tempted to mark it up by 35%, with 25% going to overhead and 10% to profit. In this case, however, you are only charging $87.75 for the same product ($65 x 135%), and your financial statement would look like Table 2.
The pitfall of using a margin percentage from a P&L is that you could wind up losing money. The correct way to use margin numbers from your financial statements is to divide by the reciprocal of that margin. Going back to that $65 piece of equipment, as an example, you would divide the cost by 65% (100% minus 35%), as this produces the $100 sales price ($65 ÷ 65%).
As I travel around the country speaking to contractors, I ask how many in the audience determine the sales price by multiplying expected costs by a number and how many divide by a number. The answer is typically about half and half. You can do it either way, but what you cannot do is determine the costs of the job and multiply by the margin goal. If you do, you will consistently underprice your jobs. You may stay busy, but sooner or later, you will not make enough money to cover your overhead, let alone earn a profit. You cannot use a margin number as a markup or you will lose money.
What Is the Right Number?
Now comes the $64,000 question: “What is a good markup?” or “What margin should I use?” I cannot answer that question, as you need to consider many factors. Your margin must provide enough money to cover your overhead, provide a profit and cover potential slippage.
Slippage occurs when you spend more money on the job than you expected. If the gross margin is less than expected after you have completed the job, you have slippage. Therefore, if you consistently price jobs with a 40% margin, but you come in at 30%, you are not managing the jobs well, and your gross margin will suffer from slippage. If you always prepare your proposals with the sales price and do not convert to the estimated cost (or budget), then you will not be able to determine the source of your slippage. You will know only that the job did not produce the gross profit dollars you expected.
Many solar contractors are constantly busy these days and yet remain always concerned about volume and competition. If you reduce your prices to get more jobs, you may be underpricing jobs so drastically that you cannot cover your overhead. This is a dangerous position to be in. It is better to do less work with a consistent profit and higher margin than to do more work at a loss. Review your financial statements to determine what margin you are making on your jobs. Separate and analyze the margin on equipment compared to the margin on labor. If the margin you achieve on labor is significantly different than the margin you attain on equipment, you should reassess any proposal you produce that has a considerably different equipment-to-labor mix.
Look at the type of work you are doing. Commercial work, for example, typically yields a lower margin than residential work. If you are considering moving from one market to the other, make sure that you have a system in place to track actual costs against expected costs—and do not confuse your markup with your margin the next time you produce a proposal.
—Leslie Shiner / The ShinerGroup / Mill Valley, CA / shinergroup.com