Defining Real Revenue in Construction

You may have heard the term real revenue, but how do you define it? In construction, it’s a powerful concept worth knowing, but what can you do with it and how can you use it to run your construction company? Let’s talk about it.

Topics we cover in this episode include:

  • What is real revenue and where does the term come from?
  • Real revenue avoids confusion around job cost vs. overhead
  • How real revenue lets you know if you’re using the right overhead rate
  • Real revenue and cash flow management

LINKS

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

TRANSCRIPT

[00:00:05] Wade Carpenter: You may have heard the term real revenue, but how do you define it? In construction, it’s definitely a powerful concept worth knowing, but what can you do with it and how can you use it to run your construction company? Come on in, let’s talk about it.

This is the Contractor Success Forum. If you’re new here, I’m Wade Carpenter with Carpenter Company CPAs and my co host here is Stephen Brown with McDaniel Whitley Bonding and Insurance.

Stephen, you may have heard the term Real Revenue from myself or Rob, but any initial thoughts on what this means to you?

[00:00:35] Stephen Brown: I don’t know. Real Revenue sounds to me like your net income after all expenses are taken out. I don’t know. Tell me, Wade.

[00:00:45] Wade Carpenter: This was actually a request from a YouTube listener that was looking at one of our recent episodes and asked this question, and I wanted to try to explain the concept.

So, number one, appreciate the feedback from our listeners.

What is real revenue and where does the term come from?

[00:00:58] Wade Carpenter: But, as I reflect on what it is and what it’s come to mean, I think there’s a lot of powerful lessons.

So where does it come from? Well, it comes from the book Profit First by Mike Michalowicz.

We talk about that book all the time on here. And Mike’s simple definition of that is your construction income, minus your materials and subcontractors. That’s all it is.

Mike’s reasoning on this is materials and subcontractors, those costs are going to other people. And they are not yours to use for your overhead, profit, taxes. Basically, what’s left over after materials and subs are what you have to run your company off of.

So with that, I think when Mike Michalowicz was writing the book, that was his attempt to equalize what the percentages should be for various levels of income.

He wrote the original book to cover all industries. And, again, if you think of materials and subcontractors going to other people, and I’ve used the example before, you’re a million dollar contractor, but $800,000 is subbed out for materials and subcontractors, you’re really only a $200, 000 contractor, right? That’s all you have to run your overhead off of, you to take a home profit home, and you to pay your taxes with.

So, in Mike’s thinking, yes, you do really think of your business in a little different light if you’re thinking, hey, I’m a $200,000 contractor versus a million dollar contractor.

[00:02:31] Stephen Brown: Right. That makes a whole lot of sense.

[00:02:33] Wade Carpenter: But Mike is a very smart guy and actually I was very fortunate. He actually called me two days ago on a different subject and I really appreciated him doing that. So, I don’t know if he’s going to be listening to this, but I really appreciate his input on that. But, I don’t think he really realized how profound the definition is for construction, especially after I’ve been implementing Profit First over the last few years.

And it helps explain some things that you and I probably deal with all the time, but you don’t even think about.

[00:03:05] Stephen Brown: You know, the whole perception of what you think about uh, what are you doing a year in sales, you throw a high number out, that’s gonna impress most people, they don’t really understand it. The only person you need to impress is yourself.

What is the real revenue over your costs? I think that’s a great definition of real revenue. Take out your subs, your materials, your pure job cost.

[00:03:28] Wade Carpenter: Since you brought that up as far as like revenue, people want to say, I’m a 10 million contractor or whatever that number is, that’s the number they hang their hat on. And there’s a saying that it’s like revenue is vanity, profit is sanity.

Profit is what you have, and that’s what you should be chasing, not revenue. So, there is big power in this simple definition, and we’ve had conversations a few times on this podcast. We’ve done some episodes on what is job cost, right?

Real revenue avoids confusion around job cost vs. overhead

[00:03:58] Wade Carpenter: So, this definition avoids the confusion about what should be in job cost and what should be in overhead. Why is that? Number one, when you’re figuring out job cost, even if a contractor has the worst job cost records, usually they can, if they really needed to, they could go pick out the subcontractor bills that they paid. They could pick out materials for the most part they paid, unless they’re running to Home Depot every five minutes to get ten dollars worth of stuff.

 These are direct costs, so you know exactly what you got in that particular job as far as that’s going out. So number one, I like the simple definition of this.

Real revenue lets you know if you’re using the right overhead rate

[00:04:37] Wade Carpenter: So again, this also gives me a clue as to hey, are we knowing if we were using the right factor in our business? Are we using the right overhead rate? And that’s another question we get all the time, because again, if you’re a project manager and somebody is piling job costs on your job you shouldn’t have to pay for accounting or, all these other things.

Now, the owner usually wants to pile everything in job costs on there to make sure they cover it. So, this avoids that confusion. These are these direct inputs that you can usually track, even if you’ve got the worst system. And it’s a quick definition of whether we know if we’re winning or losing, right?

I guess I’m going to throw it back to you, because when we’re thinking about what it means, if you’re looking at one contractor and they give you financial statements, you compare this year versus last year, have you ever looked at that contractor and seen a very big difference in the gross profit margin from one year to the next?

[00:05:36] Stephen Brown: Absolutely.

[00:05:37] Wade Carpenter: Okay.

So, then you start asking why. You see some kind of slippage if it’s going down, especially if you’re paying attention, right? So then you wonder what’s going on? Your brain immediately is like, what’s going wrong in this business?

And there’s a lot of things that could be happening, but you think, well, did we have a disaster job? Did we have a position where somebody just does not know how to estimate? And I don’t know that this necessarily answers those questions but it does give you a really quick and dirty look at it.

[00:06:11] Stephen Brown: I’m just fascinated by this concept and what you’re explaining to me, because I’m listening to it as someone who looks at financial statements all the time, all day. Different contractors, I’m looking at their working capital, I’m looking at their net worth. Their net worth is based on the profits that they’ve made after paying all their expenses. These are the key elements that I look into. And understanding what real revenue means, I think it’s a great concept. It’s a great mindset, too. Just like Profit First for contractors is a great idea, as far as I’m concerned.

[00:06:47] Wade Carpenter: Well again, this came from Profit First. I couldn’t find any reference to it outside of Profit First, but it helped me explain somethings that I’ve been trying to deal with for many years. And so, again, a CPA sends you a financial statement and they’ve got a summary financial statement that all it says is revenue minus cost of goods sold is gross profit and you start looking at that number.

Doesn’t your head sort of go like what’s wrong if you see a big slippage?

[00:07:14] Stephen Brown: Absolutely. And then you immediately look at, you know, what overhead numbers were applied to it, because you have to keep going through overhead to get to the bottom line, that income.

[00:07:27] Wade Carpenter: Then we start digging into the details, but sometimes we can trace it to obviously observable things like material supply chain and the rapid spike of cost during COVID, but other times it’s not so obvious, right?

Sometimes it depends on the mix of your jobs. Maybe you started doing a different type of job, or more of one type of job, and that can skew it. It could be that, as I said, before we subcontracted more of the job out. Maybe we lost some labor or something or specialized something. And we’re obviously not going to make the same kind of profit sometimes if we’re subbing the job out. But, again, just want you to think about the concept. So if you’ve got somebody that does a million dollars in revenue that does strictly construction management, they’re not subbing everything out, they’re doing all this for the owner, versus that same revenue, a million dollar revenue, for a general contractor that’s doing all their inputs, who’s making more money?

[00:08:27] Stephen Brown: Well, the first one, of course.

[00:08:29] Wade Carpenter: And you can’t really know that. But, again, the typical net margin for a GC is usually under 5 percent– net profit. So, to combat this, one of the KPIs that we would do in looking at financial statements from year to year or month to month, is just putting them in buckets like my five main buckets is labor, materials, subcontract, equipment, and other job costs, like insurance or you know like bonds or something like that.

And looking at the percentage, have those percentages changed, right? So if you see a big spike in materials it could be just the mix of the job. If there’s a big spike in subs as we said.

So, b ack to the concept of real revenue, it just really made me think about this differently because so many times I come in and, I’m asked to look at somebody’s financial statements and I don’t have the detail.

And maybe their P& L has 40 line items for cost of goods sold, right? Well, I can pick out these two different line items, materials and subcontractors on a P& L, and see very quickly what’s happening, if that makes sense.

[00:09:37] Stephen Brown: It does.

[00:09:38] Wade Carpenter: So that’s why , there’s some serious, you know, quick gut check on what’s going on in your business and if you don’t have good job records.

 So any thoughts how we can use that in our business and, from an overall management standpoint, cash flow standpoint?

[00:09:53] Stephen Brown: I like what you’re saying, checking what you see, having a quick picture. You know, in bonding, there’s a five minute underwriting, we call it, when we look at the financials, what we’re looking to see. And it’s the same when you’re looking at real revenue. You’re looking at the big picture.

You’re taking key performance indicators, KPIs ,to gauge what you’re seeing, and then you’re coming back and you’re taking how much was estimated and profit on all the projects that you’ve done, and seeing if it was applied correctly, and seeing what big picture that shows you.

[00:10:28] Wade Carpenter: Right.

Real revenue and cash flow management

[00:10:28] Wade Carpenter: As I’ve been working with contractors, almost five years with Profit First, it sort of changed my thought on this, so I wanted to talk about that from a management standpoint and a cash flow standpoint, if I can.

So again, that’s a quick and easy way for you to track how you’re doing on a job.

You can try to put all these other, and if you don’t have a good job costing system, quick gut check, jump in and what are these two direct costs that you could easily track to a job? And sometimes it’s easier than others, but it is a KPI, Key Performance Indicator, maybe you should look at. Because it also gives you a factor to look at where you know, Just strips out all the extra complexity of it, okay?

From a cash flow standpoint, it’s not really explicitly stated in the book. But this is what I tell contractors all the time if you’re trying to, and even there’s a Profit First derivative book for construction contractors, and I hate, I’m not trying to knock that, but he doesn’t specifically come out and say this, and for every contractor that I work with on Profit First, one of the cardinal rules is you have to create another bank account for materials and subs.

 One I just had that was a custom builder, really had no idea, but he’d been losing money for five years straight, and I guess he had deep pockets or a sugar mama, I think, that kept giving him some money to put into the company.

But, we started trying to implement Profit First–

[00:11:56] Stephen Brown: We need to do a podcast on how to get one of those. A sugar mama.

[00:11:59] Wade Carpenter: We’re probably gonna get get in trouble for this one. But his comment to me is like my materials and subs, it should be 70 percent and we were doing initial calculations and I was trying to help him come up with that and I threw it to 75, but as I’ve been looking at his history over five years, his lowest materials and subs was 90 percent of the job. And that’s where, one big learning experience that, I told him that, and so, that’s where, if you think it should be 75%, and we start carving out every dollar that comes in to this account, and you’re using 75%, but it’s really 90, you are quickly going to run outta cash in that account and figure out, hey, something is not working and–

[00:12:50] Stephen Brown: Unless you have a, a sugar mama, right, or a sugar daddy.

[00:12:53] Wade Carpenter: Well, right.

[00:12:54] Stephen Brown: Yeah, I’m sorry. I’m not going to let that go, but keep going.

You’re right. You’re right. That’s a great point. I didn’t mean to minimize it. You are looking at a number that’s way off what you think it is.

[00:13:06] Wade Carpenter: But the thing is, this contractor had gone on for five years and had continually been putting money in, and I really don’t understand it, but sometimes you see fluctuations and if you’re just looking at a tax return or something and we do some things to knock down profit, but these two inputs are not something that you really can skew as much, and so if you’re missing a mark on that.

And you run out of cash in your materials and subs and you don’t have time, money to pay your suppliers, you’re going to quickly wake up and have this epiphany, hey, these numbers do not work. Maybe I’m bidding this wrong. Or maybe I’m not taking things into account.

And again, with COVID, like we had all the supply chain, sometimes we can explain that. But I think what it does, number one, is gives you a much quicker wake up call.

 I wish I had been advising contractors on Profit First before 2008 9 10, because they would have come to some conclusions long before they did and some of them went out because they did not have these things.

So, again, if we’re short on that, is it for a particular job? Have material costs gone up? Did you sub more out? And if there’s a reason for it, we’re going to need to make a change to our percentages.

Now, the other part of this, and , this guy also had that same exact problem. And , I’ve got another meeting this, in a few hours where new contractor wants to talk about what is my overhead percentage?

And you can go into a thousand different calculations and get very detailed on what this should be, but in working with Profit First, if we got our materials and subs carved out, and then we’re saying X amount should be put aside for profit and taxes, and the owner’s compensation, the only other bucket really left is your operating expense account.

And that’s supposed to cover your overhead, and, debt service and all those other things. And in this definition, it might be carving that definition up a little differently, but if your overhead is way too high, just say it’s 20 percent overhead factor, and you’ve been bidding at 10 percent overhead, number one, that gives you a very quick gut check. It’s hey, I need to be bidding my jobs higher. I need to put a bigger factor in for that and the profit. If you’re looking for a certain profit, you’re not going to hit it if these percentages are not going to fall true.

[00:15:24] Stephen Brown: Makes sense.

The only thing you could remotely consider good news in a scenario like that is if you lose money on a job you don’t have to pay as much in taxes. Other than that, there’s no give.

I still think back to this, this fairly young man, but he’d been in the industry for a while, but he just had a baby, and he’s

[00:15:44] Wade Carpenter: like, I really gotta wake up and make this business work, and that for me was like, hey, you really did need to make some drastic changes, and in this particular case, I think the jury is still out on whether this guy is actually going to make those drastic changes, but he’s going to quickly see that this is not going to work if you have really poor job records, this is a really quick gut check, am I bidding my jobs right? Am I winning the game?

So that is my expanded definition of really what real revenue is.

[00:16:16] Stephen Brown: I think that’s a great topic and yet again, once you realize that and you’re losing profits you thought you were making, you’re losing money on the jobs, best thing to do is realize it and then start doing something as soon as possible about it. Because it just doesn’t go away.

And I’ve seen so many contractors work themselves out of difficult situations, and been in business for a hundred years, so it’s part of the construction industry, but we’re hoping as a listener, you can understand these concepts and implement them sooner than later.

[00:16:51] Wade Carpenter: Right.

And one final thought on that as well is, cash flow and growth in construction is tough. And when you’ve got these percentages carved out, well if you’re bidding properly and you dialed in your materials and subs, then you’ve got that percentage, and if it stays true, you’re always covering the materials and subs as you grow.

The other part of growing, and again, the mentality of the real revenue also is am I a million dollar contractor, now I’m a five million dollar contractor, I think I can go buy that new ford F 150 Raptor, $100,000 pickup truck, start living the life. And, I see when contractors grow, their overhead grows disproportionately.

So having the operating expense side of this as a percentage of your– sometimes it should not grow as much as that, but it actually does artificially constrain it.

What should be happening, you should be starting to get more cash built up in your Operating Expense. So maybe then you can start putting it into your profit or putting it back for the growth to grow into it. So

[00:18:02] Stephen Brown: And I can say from a surety bonding standpoint, uh, bonding underwriters love it when you’re taking money out of the company like you’re supposed to. That means all your other systems are in place, and you have enough working capital

and net worth in your company to deal with potential hardships and to fund future growth.

Well again, you know, this came from Mike Michalowicz , you know, head of Profit First. And he is an incredibly smart guy.

[00:18:31] Wade Carpenter: But I don’t think he realized how profound this is really for construction. And that’s my take on it.

[00:18:36] Stephen Brown: I love it. And we do have Mike on an earlier podcast, if you want to dig around and find it.

[00:18:44] Wade Carpenter: That might be interesting. I might invite him back to see if he might want to explore this topic with us.

[00:18:49] Stephen Brown: Okay.

[00:18:50] Wade Carpenter: Okay, well, I think we probably need to wrap up unless you have any other thoughts on this.

The one thing I did want to say is, again, thanks to our listeners for putting this topic out there, and we are listening to what you say are not making sense to you. If you have questions about that, or if there are topics we don’t talk about, we want to hear from you. So, please do comment on the YouTube channels or the social media or the podcast channels wherever you can. Reach out to me or Stephen, and we would love to talk about it if the concept isn’t clear or you want to learn how to implement it. Don’t hesitate to reach out to us and we’d love to talk to you about it.

[00:19:27] Stephen Brown: Absolutely.

[00:19:28] Wade Carpenter: Thank you all for listening to the Contractor Success Forum.

Check out the show notes at ContractorSuccessForum.com, or on the Carpenters CPA YouTube channel for more information. Consider subscribing and follow us every week as we post a new episode. And we will look forward to seeing you on our next show.