Budgeting Smarts for the Startup Contractor
In Start Your Own Construction and Contracting Business, the staff of Entrepreneur explain how you can get started in the construction and contracting industry. Whether you’re interested in building homes or prefer contracting the services needed to get the job done, this guide will help you determine what type of construction or contracting business is right for you. In this edited excerpt, the authors dissect a typical budget to help you learn to create one for your new business.
While there are numerous reasons businesses fail, money woes and financing issues rank near the top, especially for companies engaged in contracting. Many contractors fail to correctly recognize their true cost of doing business and thus fail to properly price their services accordingly. It’s interesting to know that in the same geographical area of the country, competitive bids for the same work from several contractors can differ by as much as 30 percent.
Does this mean that some contractors deliberately overcharge their clients or that others are giving the work away? Absolutely not. There are typically legitimate reasons for a wide variance among bids for the same work. Contractor A, for example, may have a larger, more stable, and more experienced workforce who demand higher wages, while contractor B may work out of his home, have few employees, and thus have very low expenses. However, contractor C may not truly understand and account for all of his expenses and therefore actually undercharge clients.
Contractors who have a reputation for excellent work that’s completed on time and within budget are usually able to charge more than the contractor who’s late, installs the incorrect product, and adds “extra charges” when the project is completed.
Establishing a budget for your business is a key ingredient to success. A contracting company may have the most skilled employees, the newest equipment, a top-notch sales team, and a creative advertising and marketing program, but failure is destined if the company doesn’t have a comprehensive financial plan. The budget is the first step in creating this plan because it:
- Helps plan for the future
- Helps plan and manage your money
- Helps identify problems before they occur or get out of hand
- Helps you meet your goals and objectives
- Improves the decision-making process
- Increases employee motivation
- Helps keep costs under control
Many new business owners begin their budget process by trying to determine what their total revenues will be for the year. They think that by considering revenues first, they’ll be in a position to know how much money they can spend during the course of the year. What they often overlook is consideration of how they’ll achieve the projected revenues. Merely knowing or guessing annual revenues doesn’t provide a strategy for pricing your services nor does it instill any kind of spending discipline. Projected revenue is something you cannot necessarily control, since you don’t know how many jobs you will get and how much of that revenue may not occur based on factors that are out of your control, ranging from a recession to weather conditions to a major competitor opening in your area of business.
Conversely, spending is something that you can control. You can decide how much you’d like to spend while knowing your minimum needs. Sure you might like a large office space, but you might be better off taking a more realistic approach and budgeting for a moderate-size office.
The budget process begins and ends with a detailed and organized system that projects annual spending in various categories and then uses these spending amounts to determine the amount of revenue needed to pay for the spending, leaving enough at the end of the year for a profit.
The first part of a budget you’ll need to determine is direct costs, which are expenses specifically related to projects completed by the company. It includes materials, labor and subcontractors, if any; it also includes the rental of any equipment that might be required to complete the projects.
One of the most difficult concepts for new contractor-owners to grasp is the true cost of labor. An employee earning $10 per hour actually costs their employer much more than that. In addition to the hourly wage, the employer incurs costs in the following categories:
- Social Security and Medicare taxes
- Unemployment taxes, both federal and state
- Workers’ compensation insurance
- General liability
- Paid holidays and vacations; sick days
- Health insurance premiums
When you combine these costs, which we call the “labor burden,” you’ll get a truer picture of your actual cost of doing business.
Every business has costs that it incurs regardless of the level of business activity. These are amounts due on a regular basis and are fairly constant from one year to the next when adjusted for inflation. Fixed costs include expenditures for items such as:
- Officer and office salaries
- Interest expense
- Rent and utilities
- Telephone service
- Advertising and marketing
- Ban payments
- Capital equipment fund
The third category of spending is called variable expenses because items here usually change in real terms, or dollar amounts, as the level of business activity increases. In addition, they tend to remain about the same percentage of direct costs. In other words, if direct costs increase from one year to the next by 15 percent, it is likely that as a group variable costs will also rise approximately 15 percent. An example of variable costs is the cost of travel expenses. When business activity increases, a company is more likely to have employees travel to more work locations for client meetings as well as work on the job. Other items we also include in variable costs are:
- Vehicle maintenance and repairs
- Office expenses
- Office supplies
- Employee incentive or bonus pay
- Advertising and marketing
- Small tools; hardware
- Salesperson salaries and commissions
Well, now what? Direct costs, fixed costs, and variable costs are identified as the major components of a budget. This is all well and good, but what does it tell you, and how can you benefit from the knowledge gained from compiling these budget numbers? First it’s a valuable exercise that forces a business owner to correctly identify all of the costs of doing business. But more importantly, you can use the information to assist in setting prices for your products and services. Now that you’ve identified three categories of spending, the next step is to combine two of them and give them a new name. Each will keep its own identity, but they work together to make what is called “overhead,” which is the ongoing general and administrative expenses that are not directly related to the selling of a company’s goods and services. To that end, you’ll combine fixed costs and variable costs to calculate total overhead expense.
The break-even point is the point at which you are now covering your expenses with income. It’s important to know how much you will need in business to break even and recognize when you have reached that point. It often takes businesses a number of years before they show a profit; this is the turning point.