Now let's take a look at the fourth ingredient - profit. It's a mysterious word to many contractors, but all of you have at least heard rumors of its existence!
Kidding aside, many contractors have a false concept of profit. They believe it equates with contractor compensation, i.e., what the owner keeps after he pays his bills. By this reasoning, if a job doesn't turn a profit, the contractor doesn't make any money.
If the rest of the business world thought like that, hardly anyone would want to go into business. There's enough risk in putting at stake your underlying investment and good name. No need to make it so treacherous that you have to worry about where your next meal comes from.
That's why we noted in the first article about "Invisible Overhead" that every contractor should take a salary draw and build it into his pricing. This enables the owner to at least cover personal and family expenses while building the business. Relying on money that may or may not be there at the end is like going on combat patrol without a helmet and flak jacket.
Adding to the peril is the widespread practice of drawing a fairly small salary and paying oneself a large year-end bonus when times are good. Not only is this hard on family budgets, the IRS takes a dim view of oversized bonus distributions. The taxmen may look at them as attempts to dodge corporate dividend payments, which are subject to corporate and personal taxes. It's one of the top flags used for singling out business owners for audits.
Take a cue from the dot.com world. One of the shining stars of that universe is Amazon.com. Founder and CEO Jeff Bezos was declared last year's Time magazine "Man of the Year," even though Amazon.com has yet to turn a profit, and has lost around $600 million since it started.
Yet, CEO Bezos is not a poor man. You can bet he pays himself a handsome salary, even though it contributes to his company's mounting losses. Someday Amazon.com may turn into a profitable business, or maybe not. In either case, Bezos and his loved ones are not going to be wandering homeless in the streets.
So it goes throughout the big business world. Not every company is a winner. Some lose money consistently. Yet, you don't see their executives and managers struggling to make ends meet until they turn a profit. They pay themselves commensurate with their job stature, even if their paychecks help drive the company deeper into the red. Drilling contractors need to think the same way.
ÙRetained EarningsÓProfit must be separated from income. The real purpose of profit is to provide capital for reinvestment, and/or to pay back loans you may have taken out to grow your business. The business world likes to refer to profit as Ùretained earnings.Ó The earnings get retained to fund new rigs, new buildings, new equipment, new services, expansion into different markets and other aspects of business growth. Whatever you canOt fund out of retained earnings, you must borrow or pay out of your personal income. Which makes the most sense?
Profit also can be a source of profit sharing and bonus plans for the owner and employees. In this sense profit can be part of owner compensation, but it should represent extra income as a reward for business success, not what you depend on to live day-to-day.
How much profit you build into your prices is entirely up to you. I donOt have data available for drilling contractors, but I do know in most construction trades contractors tend to average merely 2-3% net profit - when times are good. To some extent this is misleading, because the industry is dominated by small closely-held businesses that do their best to avoid taxes. Most of you would rather sink money into the business or spend it on owner and employee perks than pay almost a third of your profits to Uncle Sam.
I wonOt argue with this. It makes sense as long as it doesnOt retard growth - and as long as you're confident you can justify all your perks to the IRS. Keep in mind, though, avoiding taxes isnOt the main purpose of being in business. Even if you have to pay Uncle Sam $3 out of every $10 you make in profit, that still leaves $7 to fund expansion and reinvest in the business and your people.
Paying taxes isnOt the worst thing in the world - and avoiding taxes because you donOt make any money isnOt reason to jump for joy.
Calculating ProfitWhether your profit target is great or small, it's important to build profit into your selling prices. Here, I'm sorry to say, is where we get into another fundamental misunderstanding by most contractors. To illustrate, we'll conclude with a sample problem as follows.
Suppose you take on a job for which you calculate the total cost to perform - including materials, labor and other direct costs, plus overhead - adds up to $1,000. You want to make a profit of 10%. How much do you have to sell that job for?
Hint: The answer is not $1,100. We'll clue you in next month.