Annual Budgets in Residential Construction
Since the beginning of time, humans have used tools to help guide them in the right direction. From the North Star to paper maps to GPS satellite navigation, people have always had a plan to get them where they need to be.
That same concept applies not only to where you want to go in life but to where your residential construction business should go as well. Because if you aren't mapping out the route you want your business to take, how will you know if you are moving forward or just going in circles?
Even if your business goals for the coming year don't include planned growth and are taking more of an organic approach, you still need a way to see your business's performance from the ten-thousand-foot view to help guide its course.
That means ensuring you set up an annual budget for your remodeling or custom home-building business towards the end of your fiscal year and tracking it monthly.
Why You Need a Budget
As a residential construction business owner, you have a goal for every project you undertake: make it profitable. That's why you create and manage project budgets and track your costs against them to measure profitability.
The same strategy applies to your business as a whole. We use business budget planning to predict your business's high-level Key Performance Indicators (KPIs) and keep track monthly to ensure we're pushing toward them.
It's the only way to know if you're staying on track with the high-level targets you set for the year. By monitoring your performance monthly, you can quickly address issues with your profitability and pivot where you need to.
The Six KPIs
A small business budget is your company's scorecard, and it allows you to see how you're spending money and where you can make adjustments if needed. It breaks down into six main components:
Increasing Gross Revenue
In simple terms, increasing your Gross Revenue typically means you have a greater opportunity for profit in the year. This isn't always true in the case where you are not pricing your work properly and simply taking on more non-profitable work. But if you're looking to grow your business and increase your cash flow for the upcoming year, then increasing your projected revenue should be an annual goal for your business budget.
Particularly if you're a small business owner operating a construction business that is performing at less than $1 million gross revenue annually. Most entrepreneurs within this revenue range are working 12-hour days consistently, not paying themselves a proper salary, and feeling like they're on a hamster wheel.
Budgeting to grow to over $1 million in gross revenue is a good idea because it makes hiring more employees, adjusting your salary, and reducing your working hours easier because there are simply more dollars to spread around.
Companies that are generating over $1 million should aim to grow their gross revenue by 20-25% year over year. When you're operating at that scale, the gains needed to amplify your results aren't as massive as when your business operations are under the $1 million mark.
For some residential construction businesses, the focus is more on "mechanizing" instead of increasing gross revenue. Here, it's about becoming more efficient and increasing profitability within the volume of work you're accustomed to. It reminds me of a company I coached for a couple of years that came to me at $ 4.8 million in annual revenue with the goal of mechanizing. The following year they posted a $7+ million revenue because through working on their efficiency, they were able to naturally take on more work.
One final point to remember is to set a realistic budget and not let ego get in the way when setting gross revenue targets. Companies that are over-ambitious about the volume of work they want to perform versus what their current team can handle only set their clients, teams, and themselves up for disappointment.
Cost of Goods Sold
This category covers the costs involved in performing the work itself and has inputs from three categories: Labor, Raw Materials, and Trade Partners.
To ensure you are profitable, the percentage of COGs to gross revenue should never exceed 78%. If your accounting software is showing you a higher number, then it's generally because of one of these three situations:
You are NOT adding the right markup amount to your cost of goods sold.
Your accounting software isn't accurate or up to date.
A combination of #1 and #2.
I often see companies struggling with accounting errors and misleading reports. If you need help getting your financials in order, CLICK HERE TO JOIN THE BUILD AND PROFIT SYSTEM.
Increasing Gross Profit Margin
Your gross profit margin is the gap between what it's costing you to do work versus what you're charging clients for that work. That gap is what pays your overhead expenses, including your owner's compensation, and supplies your business with its paycheck – Net Profit.
⦿ In Fixed Cost construction, the typical range for a healthy business is 30 - 33% in GPM.
⦿ In Cost-Plus construction, the typical range for a healthy business is 22 - 26% in GPM.
Remember, markup and margin are not the same thing – click here to learn more.
During your annual budgeting process, you should review your GPM on individual projects and globally across your company's income statement (aka PNL) from previous years. If you don't see a number in the above ranges, you've got to raise your pricing.
The financials you track against your budget help you determine what your gross profit margin is and where it needs to grow to in order to ensure you have the right contributions to operating expenses, owner's compensation, and net profit.
If you need help understanding your financials and perfecting your pricing model so you can hit those numbers above, CLICK TO JOIN THE BUILD AND PROFIT SYSTEM.
Overhead Expenses
This category comprises your fixed costs and variable costs encompassing new equipment, capital expenditures, and administrative salaries, for example. Many construction companies wear "low overhead" as a badge of honor. But this can be counterintuitive as you often have to spend more to earn more.
Let's go back to the example above about businesses that operate at less than $1 million in revenue. If that business isn't spending money on overhead for an office administrator, for example, to help with data entry, filtering client leads, and processing invoices, payments, and expenses, those tasks will continue to fall to the business owner and overshadow their opportunities to work on securing new business.
Generally speaking, you should see your percentage of business expenses to gross revenue sit between the 5 - 15 % range. Companies that sit below 5% are usually stymying their own growth in the pursuit of being "lean." On the other hand, companies above 15% are often too bulky in the backend of the business for the size of the business itself.
Sometimes, companies do, in fact, need to curtail their overhead spending, but only do this alongside a solid financial plan and a fair agreement among your team that you can maintain the revenue range you're looking for with the current personnel.
So don't be shy about spending in your overhead because it's HOW you'll get to where you need your business to be. When you grow your gross revenue, the percentage of your overhead cost into that revenue will decrease even though the dollar value increases.
Increasing Owner's Compensation
Two of the most important things I constantly tell clients are that they need to:
Respect their business
Respect themselves in their business
Most business owners focus on paying their employees and their bills and take whatever is left for themselves. They work 70+ hour weeks for minimal salaries so that they can "reinvest" that money into their business because they think the business can't afford to pay them properly.
But here's the thing: if your business can't support paying you the salary you're worth, then it isn't as profitable as you think it is. And that needs to change.
Using a budget helps you determine whether or not you're pricing your work correctly by ensuring there's a large enough gap between your cost to perform work (COGs) and the amount you're charging for that work (COGs + Markup) so that you can increase your owner's compensation to a level that is commensurate with what you're worth.
As a general rule, we follow the "Rule of 20," which says you should aim for 10% of your Gross Revenue in terms of Owner's Compensation and the same for Net Profit. I often get asked by clients in the $10+ million range if that rule still applies. My answer is simple: You should pay yourself what you are worth, and to grow a business to that scale means you deserve $ 1 million in annual compensation.
Increasing Your Net Profit
Lastly, using a budget is critical to ensure that your revenue, cost of goods, overhead expenses, and owner's compensation numbers are solid enough that your business is generating a proper net profit every year.
Otherwise, why are you in business?
We follow the "Rule of 20" here as well in that we look for a 10% net profit on your income statement. This means that on a $1 million revenue, you earn $100k as an owner, and your business earns $100k.
How To Set Up Your Budget
Your residential construction company's yearly budget is a target that you'll compare your actuals each month to see how you're trending financially. So it makes sense to set up your budget to mirror that document.
Gross Revenue
The first thing you want to do is start with your topline revenue. In order to predict the gross revenue for next year, we look at a few things:
All the work you've completed to date
Your remaining billables for current projects this year, less the spillover into next year
Active design, estimating, preconstruction, and leads in your pipeline - all of which you can track by implementing our Master Projects Calendar in the BUILD AND PROFIT SYSTEM.
But what do you do if your pipeline isn't full for next year?
The first thing I will ask you is how much you are spending on marketing. Some of you might wear another badge of honor that all of your work is "WOM" (Word of Mouth). The problem with this approach is that it isn't a predictable method of ensuring you will sell the right amount of work detailed in your annual budget.
The second thing to look at is where you were last year at this same time and then how much you billed during your current year. There is an ebb and flow in business that tells us that with consistent effort, our calendar will continue to fill up. Every business out there relies on new customers to fuel growth, so don't overthink this category too much.
The final piece is to ask yourself where you want to be in terms of revenue by the end of your next fiscal year. Stay within reality when answering this question, and consider your team size, market economics, and the type of work you are currently doing. A general rule of thumb is around 20 - 25% year-over-year. So, if you did $2.5 million this year, aim to be around $500,000 - $625,000 higher in revenue next year.
Cost of Goods
The best way to set a budget for your cost of goods is to look at what you spent last year and use a proportional percentage to calculate how much they will represent this year, taking into account how much more business you plan to do, adjusting for increasing prices for materials, and determining whether you plan to expand or downsize your team or subcontract out more work to trade partners.
For example, let's say your company did $2.5 million in business last year, and your cost of goods was 72%. Whatever your projected gross revenue is for this year, assume 72% of that total will be your new cost of goods, and then, within that entire category, break that 72% down into materials, labor, trades, etc.
Gross Profit
At this stage, you've budgeted your gross revenue for the year and your estimated cost of goods. The difference between the two is your gross profit margin.
Remember, your gross profit margin comes from the markup you add to your cost of goods sold. Your annual budgeting period is the best time to re-evaluate your markup to ensure you're going to reach your goals.
This is a key number because it's the bucket of money that will be used to fund your overhead expenses, owner's compensation, and net profit.
Overhead Expenses
From a big-picture perspective, the more you grow your gross revenue, the higher your overhead costs are in dollars, but the lower the overall percentage of overhead costs to gross revenue.
Assuming, of course, that you're pricing your work correctly.
If it's any higher than that, you may not be selling work at a high enough rate to cover your overhead and owner's compensation. If that's the case, we need to change that. Click here to learn how the BUILD AND PROFIT SYSTEM can help.
To figure out how to budget for your overhead expenses, review your income statement from last year and ask yourself these questions:
Is there a cost here I won't spend at some point next year, like a car payment that ends mid-year?
Conversely, is there a cost that isn't here that I'll need at some point next year, like finally getting a shop so you can stop storing your tools and overflow materials in your garage.
Is there something I'm not spending enough money on, like marketing and advertising? Most businesses don't allocate the proper marketing budget, which was particularly noticeable during the pandemic.
Are there any areas within my overhead expenses that I could reduce my spending on?
One of the biggest parts of budgeting is looking at your current overhead spending with a critical eye and determining what you need to spend money on and what you don't while also planning for unexpected costs. Don't be afraid to spend money where it's needed in order to grow your business, but a little frugality will also help to keep that spending in check.
Challenge yourself when allocating amounts in the overhead section of your annual budget in these often underserved areas:
1️⃣ Marketing: Every business needs to be marketing, but I often see very little in this category. It is a business activity, not something that you do when the pipeline feels a little light. It includes annual updates to your website, finished photography of your projects, submissions for awards, etc.
2️⃣ Advertising: A second cousin to marketing, most spend almost nothing in this category. Where marketing is posting on social media, advertising is sponsoring posts and your profile on the same platform. Related but different.
3️⃣ Personnel: Office administration, bookkeeping, accounting, coaching, and other personnel that are pivotal to your growth and success need to be consistently added to your team annually. Don't fall for the trap of overloading employees until the bubble bursts. Think about pressurizing workload like a 15amp electrical circuit – 80%.
Owners Compensation
The second part of overhead expenses for your construction business is owner's compensation.
Business owners/operators are notorious for underpaying themselves for a variety of reasons. Most often, it's because they think their business can't support their salary or they need to "reinvest" that money into their business.
There are two problems with this line of thinking, though.
The first is that by not paying yourself a proper salary, you're treating yourself like an underappreciated and underpaid employee. Second, you're not truly in control of your company's financial picture.
If your business truly isn't profitable enough to pay you properly, here's what you need to do:
1️⃣ Calculate and plug in 10% of your gross revenue target for owners comp. If you're doing $2.5 million + 20% next year = $3.0 million, then plug in $300k for your Owner's Comp.
2️⃣ Calculate what your markup needs to be to hit the right GPM in order to realize this.
3️⃣ Talk to your accountant and bookkeeper about putting yourself on payroll so you can pay yourself first. As a side note, your accountant will often persuade you to take dividends instead to save on taxes. There are a variety of reasons why I don't agree with this strategy, but the main one is that if you're not paying yourself properly, then it's irrelevant.
Net Profit
At the end of the year, your business should be making a positive net profit of at least 8 - 10% if you're sub-20 million in annual revenue. That means ensuring you are pricing your work correctly to generate enough gross profit to cover your overhead expenses and owner's compensation and have money left over to reinvest into the business.
You should be plugging that percentage into the document at this point in the budgeting process. Then, work backward again to calculate the right markup so you can realize this profit. After all, isn't this to the point of being an entrepreneur?
Where Do You Keep Track Of Your Budget?
Your annual budget is a financial document, so it makes most sense to keep it tied to your other financial software. Generally speaking, that means using QuickBooks Online or other accounting and budgeting software.
While QuickBooks offers the ability to build your annual budget in the same platform as your expenses, the downside to QuickBooks, in particular, is that it's not user-friendly.
An alternative solution is to use a budgeting template and get one-on-one support through the BUILD AND PROFIT SYSTEM.
What Else Should You Plan For in Your Budget?
Along with using your budget to chart your financial goals for your business and track what you're spending versus how much money you're making, there are two other things you should be using your budget to plan for and track:
OCRA (Operating Capital Reserve Account)
Personal financial advisors always recommend saving 3-6 months' worth of living expenses in case you find yourself out of work due to illness or downsizing.
An OCRA is an emergency fund that works in the same way but for your business. It ensures you have money set aside in a separate account to cover overhead expenses for your business in the event of a slowdown or other economic event.
In pre-pandemic times, we advise clients to budget for saving 3-6 months of overhead expenses to help bridge the gap, but in a post-covid world, keeping at least six months, but closer to 12 if possible, worth of overhead expenses in a separate account ensures that your business can continue to operate during lean times.
Need help figuring out how much this is for your business and how to save for it? Click here.
Debt Repayment
If your remodeling or custom home building business is carrying debt, then paying it off should be a top financial goal for your company, and using your annual budget is a key way to determine how to best service that debt obligation.
Much like how you would budget for how much money to put aside in an OCRA, during your budget planning process, you need to determine how much money your business should put towards a debt repayment plan and for how long.
The Bottom Line on Annual Budgets
An annual company budget is a key component to ensuring you are making informed decisions about how to run a profitable construction business -because you can't rely on your bank balance to give you a clear picture of whether or not your business is thriving.
Your budget tracks the overall financial goals you've set for your business during a specific period so you can spot trends in your results to utilize this in adjusting your pricing and spending when needed. Moreover, it shows whether your company can sustain a net profit at the end of the year, which is crucial to the success of any business.
For a complete picture of what your business looks like, your budget should include the following information from your company's income statement:
Gross Revenue
Cost of Goods
Gross Profit
Overhead Expenses and Owner's Compensation
Net Profit
OCRA and Debt Repayment plans, if applicable
To build your annual budget, you need to look at last year's performance in each of these main categories, determine your growth goals for this year, and plot both sets of numbers into your accounting software or onto a budgeting template.
I created the BUILD AND PROFIT SYSTEM to help remodelers and custom home-builders gain control over their financial picture and build solid budgeting goals to help them run profitable businesses year after year.
