We write a lot about gross profit in this magazine, but judging from some of our survey results, a lot of readers are still fuzzy on the concept. The calculation is simple — gross profit equals revenue minus direct costs — but as with so many other financial concepts, the devil is in the details.

In a previous article, we looked at three ways to calculate revenue. Although the percent-complete method is best suited to remodeling, the important thing is to pick one method, make sure you understand how to do the math, and then stick with it.

With revenue under control, we turn our attention this month to the other part of the gross profit formula.

DIRECT COSTS If any accounting term is aptly named, this is it. Direct costs are all of those expenses that can be directly billed to a particular job. Sometimes called “job costs” or “cost of goods sold,” direct costs fall into five general types that should be separately tracked:

  • Materials: This includes any building material, product, fitting, or fixture that is built into or stays on the property when the project is completed.
  • Labor: This is the total cost of all employee labor for work performed on a particular job. This figure includes all payroll taxes, benefits, and other so-called “labor burden” (see Benchmark in the July/07 and Dec/07 issues). It may also include supervision time (see “Labor Pains,” at right).
  • Subcontractors: This includes the invoice amounts from plumbers, electricians, and any other individual or company who works on your project but is not an employee. Subcontractor expenses are taken directly from the statement you receive and typically include materials, labor, and the sub's markup.
  • Equipment: This includes anything you rent or lease for use on a particular job — tools, scaffolding, fencing, storage containers, and so on.

Note: If you own it and it's durable enough to last for a number of years, treat it as overhead (more on this when we discuss depreciation in a future issue).

  • Other: Anything that doesn't fit somewhere else. For example, the cost of building permits or extraordinary shipping costs that would otherwise skew material costs.

THAT'S GROSS
After all direct costs are subtracted from revenue, what remains is gross profit, also called “margin” or “overhead and profit.”

The problem, however, is that all of these concepts refer to one another in a circular way that can turn vicious if you aren't accurately charging for direct costs or aren't including everything you should in overhead. You'll also get into trouble if you are using the wrong markup to arrive at a selling price. (I'm betting at least a third of you are.) We'll look at each of these in future issues.