We have to start with an apology—on behalf of the accounting industry. For too long, the focus has been on pinching pennies in the wrong places. You’ve probably heard it all before: “Cut down your phone bill,” “Cut back marketing spend,” or “Limit your admin expenses.” While reducing overhead is important, this obsession has led to a glaring oversight. Accountants have often neglected the heart of the matter when it comes to the building industry—the Cost of Goods Sold (COGs).
The real battleground for profitability in any building project isn’t in the small change you save on utilities or administration; it’s in the effective management of COGs. This article aims to correct this long-standing imbalance. We’ll delve into why COGs are the cornerstone of profitability and offer actionable advice to ensure that both builders and accountants shift their focus to what truly counts.
Before you can wage a war, you have to know the battlefield. In the building industry, the Cost of Goods Sold (COGs) forms the terrain on which your profitability thrives or falters. But what exactly does COGs encompass in a construction project?
COGs include all the direct costs related to the construction process—materials, labour, and subcontractors. It’s these costs that you can manipulate and control to affect your Gross Profit (GP), the measure that tells you if you’re really on track with a project.
Why Measuring COGs Accurately Matters
The key to profitability lies in having a deep understanding of your COGs. An accurate measure of COGs allows you to accurately calculate your GP. And when you know your GP, you have a reliable indicator of how well a project is performing.
To bring the concept of COGs into sharper focus, let’s consider a hypothetical yet realistic scenario—a million-dollar residential building project. Crunching the numbers on a project of this scale offers practical insights into how to manage COGs effectively – and some nice round numbers.
Breaking Down the Budget
Assume your project has a revenue target of $1 million. Based on industry benchmarks, your ideal minimum gross margin (GM) should sit at around 20%, leaving you with $200,000. Overheads—covering things like marketing, admin expenses, and general operational costs—should ideally run at less than 10% – we say single figure OH is the goal – but to keep things simple let’s go with 10% , taking another $100,000 off your revenue.
What’s left? A net profit of $100,000 or 10%.
The Importance of COGs in the Equation
If you’re following the maths, you’ll realise that a whopping 80% or $800,000 of your budget is devoted to COGs. This underscores the argument that the lion’s share of your project’s financial success rests on how well you manage these costs.
It’s simple: get your COGs wrong, and your entire project could be in jeopardy. But get them right, and you’re on your way to maximising profitability. This makes COGs the pivotal factor that can make or break your project.
While understanding COGs is essential, effectively managing them is where the real battle is won. In our experience, the most effective approach to managing COGs in the building industry revolves around a three-step circular process.
The Three Cogs of Managing COGS
Step 1: Estimating
The first step in managing COGs starts even before a hammer hits a nail—it’s in the estimating phase. Here, the focus is on ensuring that you’re getting the most competitive and current pricing. Being granular in your estimates by breaking down costs into detailed line items not only helps in securing an accurate quote but also sets the stage for effective tracking later on.
Step 2: Job Costing or “Back Costing”
Once the project is underway, the real test of managing COGs begins. This is where “Back Costing” plays a pivotal role. As costs come in, it’s crucial to match them up with the corresponding line in the job and with the original quote from suppliers or subcontractors or your original labour allowance for your chippies. If you’re not diligently performing this step, you’ll be flying blind.
Without accurate back costing, pinpointing why things are off track becomes nearly impossible.
NOTE: it is impossible to do job costing and therefore properly manage your COGS if you don’t have your Bookkeeping systems up to scratch – at a minimum coding every cost to the correct job (and job stage/section) and reconciling your accounts and jobs at least on a weekly basis.
Step 3: Reporting and Analysis
The final cog in this machine is an effective reporting system. With a robust reporting system, you have real-time data at your fingertips, helping you gauge the health of your COGs. This not only keeps your current project on track but also feeds valuable data into your estimating process for future projects. It can also serve as a strong call to action to rally costs and other inputs if the job is starting to bleed margin. You can’t do any of this without micro-measurement.
This three-step process creates a virtuous cycle. Effective estimating informs accurate back costing, which in turn feeds into detailed reporting. The outcome? A clear, real-time snapshot of your COGs that enables proactive management and sets the stage for future project success.
When it comes to managing COGs effectively, even seasoned professionals can stumble. Knowing what pitfalls to avoid can make all the difference in your project’s profitability.
Muddying the Waters with Owner Wages
It’s easy to distort your financial picture by including elements of the owner’s wage in the COGs. This should be avoided. If you, as a business owner, are on the tools and actively participating in the construction, then the proportion of your time spent should be counted as a direct cost. All other wages should sit in the overheads.
Overhead Recovery in the Margin
We see builders build in overheads into the margin, then build in margin on top of this and it only creates more confusion. The purpose of the quote process is being able to measure yourself to a plan and how do you measure an ‘overhead allocation’ against a quote? Is it a % of revenue – what happens if you have a quiet month? If you are asking yourself how do you allocate overhead to a job, you are wasting your time. What you want to be measuring is, did that bathroom tiler come in over or under the quoted price he gave me. without overheads distorting the picture you’re making it a quantifiable measurement.
Manipulating Quoted Prices for Competitive Margins
In a similar way we also see builders inflating individual item costs in their quote, and then reducing the overall quoted margin to appear more competitive to external parties like clients and architects. However, it’s crucial to manage your COGs performance against the real, unadjusted cost estimates. This ensures you get an accurate read on how well you’re actually doing, rather than relying on manipulated numbers. In essence, you’re using the wrong scorecard if you rely on these tweaked figures.
Bookkeeping Not Keeping Up
When your bookkeeping function isn’t up to scratch, things can quickly go south. The key here is to have systems in place that allow for quick and accurate coding of costs to the correct job. A failure to reconcile items on at least a weekly basis can lead to discrepancies that are hard to fix down the line.
Failure to Adjust Strategy Based on Real-time Data
The construction industry is dynamic, with many moving parts. Failing to adapt your COGs management strategy in response to real-time data and unexpected changes can result in budget blowouts.
Managing COGs effectively is where profitability is won or lost. By focusing on a three-step process of accurate estimating, diligent job costing, and real-time reporting, you can secure your project’s profitability.
The battle over profitability is too important to wage without a dedicated and informed strategy. As commercial accountants who understand the complexities of the building industry, we offer not just financial insights but actionable advice. To further assist you, we also offer a specialised building industry bookkeeping service.
Get in touch today to set up a free consultation with our CFO Advisory team.
