Chapter 4
The Markup vs. Margin Misconception: The Silent Profit Killer
Just as "dinner" and "supper" mean different things in the South despite seeming similar, markup and margin are distinct financial concepts that shouldn't be used interchangeably. Confusing these terms is the most common problem encountered when working with construction business owners worldwide, and this misunderstanding has led countless companies into financial distress.
Markup is the amount added to your Cost of Goods Sold (COGS) to determine your price, while margin is the space between your price and COGS. When you mark up costs by 20% (selling a $100 item for $120), you don't make 20% profit - you make 16.7% margin ($20/$120). This critical distinction causes many contractors to underprice their work, leading to cash flow problems and eventual business failure. For example, a contractor marking up a $10,000 kitchen renovation by 20% would charge $12,000, believing they're making $2,000 (20%) when they're actually making $2,000/$12,000 = 16.7%.
A 20% markup does NOT yield a 20% margin - this mathematical relationship is immutable. If you need a 20% margin, you must mark up by 25%. For a $100 cost item, a 25% markup results in a $125 selling price, creating a $25 margin, which is 20% of the selling price ($25/$125). This relationship becomes even more critical with larger projects where small percentage differences can mean thousands of dollars in lost profit.
So-called "industry standards" around markup are destructive myths that perpetuate financial instability. The commonly cited 20% markup standard (yielding only 16.7% margin) guarantees failure when overhead expenses typically run 20-23% of revenue. Healthy contractors need at least 10% net profit after covering overhead, requiring markups closer to 50% in most cases. A detailed analysis of successful construction companies shows that sustainable businesses typically maintain markups between 40-60%, depending on their overhead structure and efficiency.
Other harmful industry standards include:
• Providing free estimates (which can cost hundreds in time and resources)
• The customer expectation of getting three bids for a "fair price"
• Using competitor pricing as a benchmark without understanding their cost structure
• Assuming all jobs should have the same markup regardless of complexity
The only true industry standard is that most construction businesses fail within five years - a statistic largely driven by poor pricing strategies. Instead of following these destructive norms, contractors should focus on educating customers about their unique value proposition, including:
• Quality of materials and workmanship
• Project management expertise
• Warranty and service guarantees
• Licensed and insured status
• Professional certifications and training
• Track record of successful projects
Successful contractors understand that proper pricing isn't just about covering costs - it's about building a sustainable business that can invest in quality employees, maintain proper insurance coverage, and deliver consistent value to customers over the long term.
Chapter 5
The Profit First System: Small Plates for Financial Health
In June 2016, Shawn's wife announced they were going to have a "lifestyle change" - words that momentarily stopped his heart. Unlike when she revealed she was pregnant with their fifth child, this lifestyle change was about nutrition. They started the Whole30 program, stripping their diet down to core food categories for thirty days - meat, vegetables, fruit, seafood, eggs, and unsweetened beverages.
Profit First for Contractors applies this same concept to your construction business - focusing on the fundamental nutrition of your business while eliminating what leaves you bloated and unhealthy. Whatever your reason for starting your business, profit is how you stay in business. The system uses five separate checking accounts (INCOME, PROFIT, OWNER'S COMP, TAX, and OPEX) to allocate funds for specific purposes, creating "small plates" for your business finances.
The system works on four core principles borrowed from dietary science:
1. Using small plates (smaller portions)
2. Serving sequentially (prioritizing what matters)
3. Removing temptation (out of sight, out of mind)
4. Enforcing a rhythm (regular financial habits)
These principles leverage psychological principles like Parkinson's Law (demand expands to match supply) and the Primacy Effect (we place significance on what comes first). By putting profit first rather than treating it as an afterthought, it becomes the focus of your business.
When you establish a rhythm with cash management, you'll know your business's status with a quick two-second bank balance check. The system creates a habit loop with a cue (income deposits), routine (following the 10/25 rule), and reward (effective cash flow management).
The four principles in practice mean: using small plates by dispersing income into different purpose-specific accounts; serving sequentially by always allocating percentages to accounts before paying bills; removing temptation by keeping profit accounts out of easy reach; and enforcing a rhythm by doing allocations and payments twice monthly on the 10th and 25th.
Chapter 6
Implementing Profit First: From Assessment to Action
Profit First is a cash-management system focused exclusively on actual money transactions - cash in and cash out. Before starting your initial assessment, gather your P&L from your last full year, owner tax returns, and year-end balance sheet. If you don't have these documents, you can still get reasonably close with estimates.
The assessment begins by calculating your "real revenue" - the actual dollars your business manages after subtracting subcontractor and material costs from your total income. This calculation is especially important for contractors because every project can have vastly different subcontractor and material costs.
For example, a homebuilder with $2,000,000 in top line sales but $800,000 in material costs and $700,000 in subcontractor costs is really a $500,000 business. This real revenue number represents the amount of money you're actually managing.
Once you have these figures, you'll apply Target Allocation Percentages (TAPs) based on your real revenue range, which will be translated into Percentages of Total Revenue (PTRs) - the unique approach that distinguishes PFC from standard Profit First methodology. This translation simplifies the system for construction companies by allowing you to allocate incoming funds without first calculating the materials and subcontractor portions.
For a healthy construction business, the GAAP percentages of total revenue should be: COGS at 65-70%, Expenses at 15-25%, and Net profit at 8-10%. These categories appear on your P&L statement. The corresponding PFC Percentage of Total Revenue (PTR) targets should be: Tax at 6-10%, Owner's comp at 10-15%, Net profit at 8-10%, and Total OPEX at 76-65%.
To design your construction business for profits, determine your PTRs using these simple starting points:
1. Set your profit PTR at 1% initially, increasing it later.
2. For owner's comp, calculate what you'd pay someone with your skills for both field work and office work, divide total owner compensation by revenue and aim for 10%.
3. For tax account, calculate last year's total taxes (including owners' personal taxes) divided by revenue to establish your tax PTR.
4. Calculate total OPEX by subtracting all other PTRs from 100%.
Chapter 7
Ripping Off the Band-Aid: Painful But Necessary Changes
The painful process of financial assessment in PFC is like ripping off a band-aid. Jason Mollak's story illustrates this - initially stressed about tens of thousands owed by a general contractor, he implemented PFC and transformed his business. Research by Daniel Kahneman shows people remember experiences based on peak moments of pain and how they end, not duration.
Many CPAs cost contractors money rather than helping them make money. While they may provide technically correct tax advice, they often focus solely on determining tax liability rather than improving business profitability. Three common pieces of costly CPA advice include: paying yourself through owner's draws (which artificially suppresses COGS and expenses), spending money just to reduce tax liability, and poor financial organization.
When you're lost, speed isn't your friend. Like a pilot flying without instruments, many contractors race forward without proper financial guidance. Now it's time to slow down and bridge the gap between your current position (revealed in your initial assessment) and your desired destination (recommended PTRs).
PFC isn't a temporary diet but a complete nutrition plan for your business. Like adapting to a Whole30 nutrition plan, implementing PFC will make you hungry - but in a productive way that motivates you to eliminate unnecessary expenses. When you view your business income through the PFC lens, you'll become more disciplined about cutting out financial junk while still fueling growth.
While cutting expenses, be careful not to remove essential "muscle" from your business. Professional services like bookkeepers and quality subcontractors are investments, not costs to eliminate. Cut the fat by reviewing every expense line item monthly and staying within budget.
When COGS is too high (often above 70% of revenue), the solution isn't cutting employee wages but raising prices. If your COGS is $700,000 on $1,000,000 revenue (70%), selling the same work for $1,100,000 reduces that ratio to 63.6%. While existing clients may resist higher prices, better clients will pay them.
Chapter 8
Starting the Journey: Small Steps to Financial Freedom
The best time to plant a tree was twenty years ago, but the second-best time is today. If you don't have a business producing profit, start planting that tree now. Begin your Profit First for Contractors implementation with manageable steps:
1. Tell your financial people about PFC
2. Set up your bank accounts (income, profit, tax, owner's comp, and total OPEX)
3. Give them clear nicknames
4. Establish your Current Percentages of Total Revenue (CPTRs)
Start with what you've historically allocated plus just 1% for Profit, Owner's Comp, and Tax accounts. The goal is to establish a new automatic routine with percentages so small you barely feel them, then adjust quarterly until reaching target distributions.
PFC is self-correcting because percentages must always add up to 100%. If they exceed 100%, you're spending more than you earn - common for construction businesses. The confusion often stems from GAAP accounting, where P&L might show positive numbers but doesn't account for all money leaving the business, like owner's draws taken from the balance sheet.
To implement Profit First, Mike recommends starting with small adjustments to your Day Zero percentages: add 1% to Profit, 1% to Owner's Comp, 1% to Tax, and reduce OPEX by 3%. For a business with $1,000,000 revenue, this means getting the same work done for $890,000 instead of $920,000.
To make Profit First work, you must cut expenses by at least 10% immediately, even though you're only allocating 3% to your key accounts. This larger cut is necessary because bills don't disappear overnight, and you'll need cash reserves for future quarterly increases of another 3%.
Establishing a financial rhythm transforms your business from reactive to proactive. Instead of checking bank balances whenever bills arrive, process allocations on the 10th and 25th of each month. This creates a disciplined habit that brings focus and productivity.
Chapter 9
Measuring What Matters: The Metrics of Success
Whether from modern management guru Peter Drucker or Renaissance astronomer Rheticus, the principle remains: "If you can measure it, you can manage it." Understanding the difference between lead and lag measurements is crucial for business success. Net profit is a lag measure - the end result of a process. Lead measures are the activities at the beginning that influence the final outcome.
While lag measures like "10% net profit by year-end" are easier to define, identifying the right lead measures can be challenging as multiple factors influence results. Implementing PFC helps reverse engineer your business by establishing metrics that matter (PTRs), revealing inefficiencies, and providing a plan to achieve desired results.
Print out all your expenses and review them line by line, asking "Do we really need this?" Eliminate broad categories like "miscellaneous expenses" and assign every expense to a specific category. If you have to stretch the definition to include an expense, that's a sign you should cut it.
For many construction business owners, especially owner-operators, the value of their work doesn't appear on financial statements. When you start charging customers for your true value, prices will increase and some customers will leave - which is actually beneficial. If you perform 100 jobs yearly at $1,000 each and double your prices to $2,000, you could lose half your customers and still make the same revenue while doing half the work.
As Brad Hams states in "Ownership Thinking," "In the absence of information, people make stuff up." Combined with Parkinson's Law (work expands to fill time allotted), this leads to people working longer on the wrong things. While you may not share PTRs or proprietary financial information with employees, you must share other business numbers with them.
When interviewing potential clients, Shawn always asks about their closing rate. Most struggling construction business owners say "We get most of the jobs we look at" and give percentages over 50%. This is concerning because high closing rates often indicate artificially low prices and minimal profits. Counterintuitively, profitable construction companies typically have closing rates between 30-50%.
Chapter 10
Avoiding Common Mistakes: The Path to Permanent Profitability
The worst enemy of Profit First for Contractors isn't the market, employees, or customers - it's you. The system is simple but requires consistent discipline, which is where most fall short. We resist cutting back on tools or vehicles, believe false industry standards, and steal from ourselves - taking money allocated for profit to pay bills or borrowing from tax accounts.
Common mistakes include:
1. Going it alone - While you can make PFC work by yourself, it requires discipline to establish good habits and break bad ones. Getting an accountability partner or joining a PFC Group is crucial for success.
2. Too much too soon - Though you might be eager to set aside 10% profit, double prices, and pay yourself properly, you need to start gradually. Start with small chunks and build up over four to eight quarters.
3. Growth for growth's sake - Many construction business owners believe success means growing larger. As Edward Abbey said, "Growth for the sake of growth is the ideology of the cancer cell." Instead of growing first and then figuring out profitability, determine what makes you profitable and build around that.
4. Not reviewing your expenses - Cash flow problems often start with expenses. Like Oprah who signs her own checks to maintain awareness of every penny leaving her accounts, you need to review all expenses monthly.
5. Stop "investing" in your company - What many construction business owners consider investing is actually stealing. True investing means allocating specific capital with calculated ROI and a plan to realize that return.
6. Dipping into the tax account - When implementing PFC, you might allocate more to your tax account than your CPA's quarterly estimates require. Never raid your Tax account thinking you won't need that money - you will.
7. Don't overcomplicate Profit First - Following Occam's razor, the simplest explanation is usually correct. PFC is fundamentally simple: that $10,000 check isn't really $10,000 - portions belong to profit, taxes, owner's comp, and OPEX.
8. Skipping the bank accounts - PFC works because it's a physical cash management machine visible at your bank. Some try implementing PFC in spreadsheets without setting up accounts, but this fails because we naturally check our bank balance when making spending decisions.
Chapter 11
Freedom Through Boundaries: The Ultimate Goal
Imagine an elementary school with a playground near a busy highway. Without a fence, teachers would feel constant anxiety during recess, fearing children might wander into danger. But with a solid fence around the playground, everything changes - you can let children play freely without worry, simply maintaining the boundary.
This illustrates how establishing proper boundaries creates freedom. Many construction business owners lack these boundaries, letting their businesses run wild until they get "hit" - whether by unexpected tax bills (SPLAT!), inability to pay themselves (SPLAT!), or running out of money (SPLAT!).
Profit First for Contractors creates these essential boundaries through PTRs (profit, tax, owner's comp, and total OPEX). With these boundaries in place and additional support through accountability, you can focus on doing the work you enjoy without fear, requiring much less effort than having no boundaries at all.
The system changed contractors like Ken Alger, who saw stress lift after just one month, and the Stitzers who increased profitability by 60% within a year. The key is starting small - even just 1% of deposits into your profit account - to build the habit and confidence in the system.
As Mike Michalowicz says, "You'll never miss that one percent," but it proves the system works and builds your confidence to grow from there. Through small, consistent steps, construction business owners can break free from the craftsman cycle and build the profitable, sustainable businesses they deserve.
