My favorite definition for “net” comes from Dictionary.com: final; totally conclusive: After all that work, what was the net result? This definition is perfect for a business like remodeling where, after all that work, the “net result” is what's left over — net profit.
Mathematically, the net profit formula is simple: Income minus Direct Expenses minus Overhead equals Net Profit (or Loss). But there are elements in the concept that still trip people up. Here's my take on the most common questions about net profit.
WHY MAKE A PROFIT? Net profit serves three vital purposes: It compensates the owner for the risk of running a remodeling company; it ensures the company's longevity; and it motivates both owners and employees.
A company that retains a good portion of its profit as cash is better able to ride out an economic slump. A standard rule of thumb suggests that you maintain at least six months of overhead expenses in cash reserves. Remember that, as an owner, you need also to provide for six months of personal expenses.
WHERE DID THE MONEY GO? It's fairly common for a company to show a paper profit but have a lesser amount in the bank. This cash flow issue might occur because you have billed clients but not yet been paid, or you have used the money to reduce debt. Or you might have taken the money out of the company as a distribution to buy a new fishing boat.
Unfortunately, it's also fairly common for a company to show a net loss instead of a net profit. In this case, unless you have enough cash reserves from prior years, you might be borrowing heavily to stay in business and pay your personal bills.
WHOSE MONEY IS IT? In theory, profit is all yours, but only if you've paid all the outstanding bills to vendors, subcontractors, and overhead suppliers to cover the time period in question.
This is an accounting issue, and only the percent-complete method is accurate no matter when you run a report. With a cash system, it's easy to overlook payables, and an accrual system might be misleading when projects straddle two fiscal years.
HOW MUCH IS ENOUGH? Remodeling gurus set a net profit goal of 10% of total annual revenue. It's a good target, but in the 22 years that I've been working with remodeling companies all over the country, it has proven hard to reach consistently.
Historically, remodeling companies have averaged about 2% net profit — the same as grocery stores — although in the last five years some well-run remodeling companies consistently netted near 10%, depending on what you count (see “Track the Variables,” to find out what affects the final number). A few exceptional companies during exceptionally good years managed profits of 12% or more. Your job, as owner, is to plan and organize the company to make a healthy net profit, year after year.
Track the Variables
Discretionary expenses affect net profit. For example, if your spouse works part-time as an unpaid bookkeeper, your profit is larger than that of an otherwise identical company that pays for these services. Bonuses and benefits have the same effect — if you don't pay them, your profit is higher than that of a company that does. The same with discretionary owner perks — such as writing off weekly greens fees because your plumbing sub is in your foursome.
Quite apart from how these things affect your tax reporting or accounting system, you should be able to back them out of the equation whenever you want to compare your net to that of other companies.
