Gross Profit is about Pricing. Net Profit is about Proportion. Contractor 20/20 Helps You Understand the Differences.
Contractor 20/20 offers a great explanation of gross profits vs. net profits in the contractor business. Your gross profit (the amount left over from a sale after you deduct the cost of goods including direct labor and parts) is driven by:
1. Your pricing
2. How accurate your cost estimates were
3. Cost of errors, waste and downtime
Your net profit (gross profit minus overhead) is maximized when your fixed overhead is in proper proportion with your sales. For a healthy service department, you might budget sales revenue as follows: 25% labor, 15% materials, 2% gas, 40% overhead and 18% profit. As you examine these numbers, you’ll see relationships develop.
In this model, to hit your maximum profit you need to budget overhead to less than 40% of sales or push sales to be 2.5 times the overhead. If the overhead you need is too high, cut unneeded costs (your unskilled brother-in-law on the payroll) or push sales. Be sure to account for the cost of getting new customers in your pricing as you push sales or advertising costs will eat your profit. Another way to set your sales goal is to multiply your profit goal by 5. Make sure you have the staff ready to do the work and the advertising tested that will be needed to drive the sales.
The other day I was doing a consult for a company that was at 8% profit on 1.6 million in sales. He wants to expand his company and is at a difficult stage of growth. His overhead is about to step up to grow. He must add another layer of management, he can no longer do it all himself and maintain quality control or his own sanity.
You should notice I said “step up”. Unfortunately, overhead does not grow in a straight line, it steps up. The layer of management he needs to efficiently grow at 1.6 million is the same as he will need to maintain sales at 3 million. He must protect profit to get himself through this difficult stage. Like a bear getting ready for winter, he needs the extra layer of fat in his bank accounts.
I preceeded to ask him the key “green light question” when it comes to pricing. “What is your current closing rate at the tech level?”. His response was “over 95%”. I then asked him if he would rather make 8% profit and keep 95% of his customers happy or make 20% profit and make 93% of his customers happy. He told me he was already the most expensive in town. (His response shows why a lawyer that defends himself has a fool for a client; even a smart lawyer needs objective control.) In my opinion the fact he is already the highest priced is really not an issue. The 95% closing rate was all the green light he needed.
I believe that most residential contractors that have service department closing ratios over 74% should be able to increase prices to drive profits, given that they have solid customer retention. This DOES NOT mean that there isn’t a downside to price increases. I have seen that as you raise prices, you lose customer retention. I have seen that with a 20% price increase, you lose 10% customer retention. That’s why you need to track new customer costs so you can spot the point of diminishing returns (when the price increase does more harm than good).
However, most are better off firing their old, cheap customers and then advertising to replace them with new customers willing to pay a fair price. Both Toyota and Cadillac make money … it is up to you to decide what level of service and image you want to deliver to your customers. Both Toyota and Cadillac make money by delivering a quality product, efficiently produced so it can be priced right to dominate their market class, then they mark-up price based on costs to drive a profit.
Get your product to market efficiently, track the cost, and then add 25% for yourself if the market will allow you to. “When the only tool you have is a hammer, every problem looks like a nail” –Phish
Everyything has its pitfalls. Some owners just keep increasing prices to cover up sloppy practices. It doesn’t work over time. Even worse, others will sell customers things they don’t need. There is no blessing in either laziness or dishonesty; ill begotten gains are quickly lost. For most companies, your overhead will drive your sales budget. The shortage between your sales budget and sales reality will drive your advertising budget. The red lights and green lights for individual moves are market driven including efficiency, scale of business, quality of service and pricing. Just ask Adam Smith, author of The Wealth of Nations and a capitalism predictor. The successful businessperson knows how to read the signs, heed their warning, and take advantage of their opportunities.
What are the signs? For example:
1. If your flat rate book is based on 50% hourly efficiency and you drop below 50%, pump up sales or drop staff.
2. If your closing rate at the tech level or CSR level is sub-par, drop prices, get better training or hire new employees.
3. If your average ticket is too low, get better training or hire new employees.
If you need to pump up sales, track down some good advertising. Test it, track its cost and add that cost to your prices and hit your sales and profit budget. Many owners work 30 years to earn 10 years worth of profit. Unfortunately, by then the damage done to their physical, mental, financial health and family relationships is irreversible.
It is a fact that the skill set that makes you a great leader of men and a great technician is often not the same as the skill set needed to set pricing and budget goals. How else can you explain the ultra low profitability and ultra high customer satisfaction rates of the HVAC industry overall? If you don’t know how to read the signs for yourself, find a good guide who will show you how. I would rather see my clients keep 93% of their customers happy with their price and have 20% profit than keep 95% of their customers happy and struggle financially.
What do you think?
Call Mike Morosi at Contractor 20/20 for all your marketing and advertising needs.