Sales Up, Profits Down? Wondering Why?
January 11, 2013
To understand the phenomenon of sales being up and profits being down, you first have to understand how 90–95% of current company owners in our industry got started. This may not be your story, but it is the story of many of today’s owners. Most company owners used to be technicians working for someone else. One day, a little lightbulb went off, and they said to themselves, “You know what? The company is paying me $X per hour, and it’s charging the customer this unbelievably high hourly rate. And you know what? If I went into business for myself, I could charge that high rate and I’d be rich!” So they thought about it for a few days or weeks, or perhaps even a few years, until one day they made the break and started their own business.
Normally, when you start your own business, you start out of your house or garage. What’s your first major challenge? Deciding how much to charge. Most new owners simply find out what everyone else is charging, and charge the same, or maybe a little bit less. The first few years go pretty well. You have very little overhead and you’re making money. No, you aren’t making what you thought you would, but you still have the vision of one day turning your company into a real moneymaking machine! So everything goes pretty well for the first three or four years, and then a strange thing begins to happen. You find yourself doing more and more work but making less and less money. You look at last year’s figures and find that sales were up 30% but profits were down! What’s going on?
How long does it take the average company to realize that it has a foundational problem? Normally one to four years—not to solve the problem, but to realize that there is one! Going out of business is normally a three-step process. If you understand the steps, it might just save your company.
Step One, profits are down and cash flow is tight. The solution? Most contractors simply do more work. Instead of working five days a week, you start to work six or perhaps seven days a week. Eight-hour days for the techs become a thing of the past. Now you’re working 10 or 12 hours a day. What’s the net result? More cash flow comes into the company. You can now pay your bills. The problem seems solved for the next 6 or 12 months. For the next 6 or 12 months, it looks as if the problem is solved. Then you find yourself right back in the same position. Sales are up and profits down. It’s time for Step Two to kick in!
Step Two begins the process of hanging on until things turn around. During those first few years you were in business, you made some money, remember? If you were smart, you pigeonholed some of it, and now it’s time to invest in the company. Step Two finds you putting your savings back into the business to buy time until everything works itself out. The additional funds help cash flow and the extra cash buys a little more time. All is well for another year or so, and then it’s back to lower profits and tight cash flow. Now it’s time for Step Three.
Step Three is often the straw that breaks the camel’s back. Sales are increasing, you’re hiring more techs and buying more equipment, and your customer base is growing by leaps and bounds. The final step—mortgage it all! Your line of credit is maxed out and you’re not paying your distributor because you need the cash to keep going. You get that second or third mortgage on your house, which buys you a little more time, but eventually you are right back to square one—out of cash, but now you have nothing left to draw from!
If this scenario sounds familiar to you, you are not alone. Many of today’s companies have followed a similar path. There are two major problems in the trades industry today that put companies out of business. The first is improper labor pricing and the second is cash flow. If you are fortunate, you will experience these two problems before you go through the three-step process of going out of business.
Solving Improper Labor Pricing
To understand how to solve the problem of improper labor pricing, you have to understand what has happened to your company over time. When you started your company, you were paying very little in overhead. You charged what everyone else charged, and the profit margin was pretty good. As the years passed, however, overhead increased. As the company grew, the paperwork monster reared its ugly head. That required office supplies, printing, computers, part-time or full-time office help, and lots of other unforeseen costs. All of a sudden, the home office was too small. The company needed more office, storage, and warehouse space—and you were paying for more utilities, insurance, and maintenance. Meanwhile, the company kept on growing! You were paying for more techs, more trucks, more gasoline, more employee benefits, and still more insurance. To maintain growth, you had to start marketing your services, which cost money, and before long, it was too much for you to handle. You could no longer work in the field and run the company. So you moved from the field into the office, and guess what? Your salary just became another huge increase in overhead costs.
What happened? The company’s cost of doing business has dramatically (but gradually) increased. What has happened to the hourly rate over that same period? Has it gone up enough to cover the additional cost of doing business while maintaining the desired profit margin? The answer is most cases is a resounding No! Worst of all, most owners don’t know how much they need to charge to cover their real costs of doing business while generating a reasonable profit.
Charging the proper hourly rate is essential to profitable growth. If your hourly rate is wrong, nothing else really matters!
Calculating Your Hourly Rate
How do you calculate your hourly rate? It’s really not all that complicated. Keep in mind, however, that hourly rates should be set based on cash flow (dollars in and dollars out), not on accounting numbers. There are two big differences between cash flow and accounting. The first is the way in which they handle the depreciation of equipment versus the cost of replacing equipment. The second is the way in which they handle loan payments.
Deprecation is an accounting term that refers to the cost you paid for the equipment years ago. Equipment Replacement Cost refers to what it is going to cost you to replace the equipment in the future. Equipment Replacement Cost then builds that cost into today’s pricing. The net result is that you will be able to pay cash for equipment when it is time to replace it. You might say this is the first “system” the company is putting into place for future profitability.
The second difference between cash flow and accounting is the way in which they handle loan payments. Let’s assume the company has a loan payment of $500 per month. Of this, $100 is interest and $400 is principle. From an accounting perspective, the $100 interest represents an expense, and only the $100 in interest shows up in the profit and loss statement. The other $400 is neither profit nor loss from an accounting perspective. However, from a cash flow perspective, the company wrote a check for $500, and the entire $500 needs to be built into the company's hourly rate.
The five steps of setting a proper hourly rate are as follows:
- Step One: Determine your real costs of doing business, from a cash flow perspective.
- Step Two:Determine how much gross profit you make by selling materials, equipment, and supplies.
- Step Three:Calculate your billable hours. Billable hours are the hours you can actually bill the customer.
- Step Four: Calculate your break-even rate. Subtract the gross profit you made by selling materials, equipment, and supplies from your total overhead cost. Next take the remaining overhead and divide it by your billable hours. The result is your break-even rate.
- Step Five: Build profit into your break-even rate by dividing the break-even rate by .85 if you want a 15% profit or .9 if you want a 10% profit.
Now that was quick and dirty, but it covers the basics. To learn more, click here for sample worksheets. These ten worksheets walk you through the process of setting proper hourly rates for a sample company. Keep in mind that you need to fill in the worksheets by department, in order to come up with proper hourly rates for each area of your own company.
Congratulations! You have just created the first system within your company. You now have a simple system to set proper hourly rates that will lead your company on a path of continued profitable growth.
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