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What is the appropriate compensation for the Owner of a construction firm? Is a healthy salary plus expenses enough to justify the business risk that a Contractor takes—or should that Contractor also be building wealth using the construction firm as an investment vehicle?
Unfortunately, there is no one right answer to these questions. However, answering the question on an individual basis does depend on the Return on Investment (ROI) a Contractor expects for their business.
To establish the desired ROI, we must first agree that there is a very high degree of risk in construction contracting. There are any number of situations that can spell an untimely end to the construction firm. A Contractor only has to suffer one of these to end the life of the firm:
- Payment delays (or non-payment)
- Unexpected weather
- Bad owners
- Unavailability of quality labor
- Litigation, and many more
Now that we can agree on the risk, we can discuss what the compensation for that risk should be.
Less Risk = Less Return
In determining which investment to undertake, a Contractor should primarily be concerned with performance. Performance is the likely return the Contractor can expect when compared to the relative risk of loss to which the investment is exposed. Meaning, the less risk involved, the lower the return the Contractor should be willing to accept.
Higher Risk = Higher Return
Conversely, for an investment of substantial risk, the Contractor should demand a substantially higher return. The customary measure of return on investment for the Contractor is the profit before tax generated as a percent of Owner's equity in the firm.
The following illustrates the ROI for an example company called XYZ Company. For the purposes of this calculation, XYZ Company shows a profit before taxes at fiscal year-end of $27,485. Owner’s equity for the same accounting period is $135,750. The formula is:
- Return on Investment = Profit Before Taxes divided by Owners' Equity
- $27,485/ $135,750 = 20.25%
- Return on Investment = 20.25%
The result of 20.25% simply means that for each $100 invested in the firm, the investor receives $20.25 before taxes. The Contractor will be able to recoup its total investment in less than seven years, based on a generic 25% income tax rate.
Join us next week as we explore inherent risk percentages, owner’s equity, and net profit percentages. If you have any questions, reach out to TSIB today!