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Gross Margin Doesn’t Tell the Whole Story

You are happy. Your job cost says that you’ve achieved a 35% gross margin on your latest job. Should you be happy? Maybe and maybe not. Gross margin doesn’t tell the whole story.

I’ve known contractors to achieve a 35% gross margin on a job and still lose money on that job. I’ve known contractors who achieve a 35% gross margin for the month and still lose money for the month. Unfortunately, this is happens frequently. Here’s why:

There is a simple explanation in slower times of the year. Even if you achieve a decent gross margin, your total sales are not high enough to cover your company’s monthly overhead. Let’s assume that your company’s monthly overhead is $100,000. During April you generate $250,000 in revenues at a 35% gross margin. This means that your gross profit is $250,000 X 35% or $87,500. Since the company overhead is $100,000, the company lost $12,500.

Does this mean that you should increase your job prices in slower times of the year so you achieve a higher gross margin? Probably not. Many contractors decrease their prices in slower times of the year. They want to at least break even so they price their jobs lower to ensure they get enough volume to cover the slower months. How much do they lower prices? To a maximum of the break even point of the company. And, they look at break even in terms of overhead cost per hour and gross profit per hour.

Understanding your overhead cost per hour and gross profit per hour are critical. Not understanding this is how you can achieve a gross margin of even 50% and still lose money on a job. Here’s how:

Assume that your service technician does a job at Mrs. Jones’ home. He charges her $300 for 3 hours of work. Your gross margin is 50%. Your overhead cost per hour is $60. The gross profit of the job is $300 X 50% or $150. Your gross profit per hour is $150 divided by 3 hours. This means your gross profit per hour is $50. Your overhead cost per hour is $60 so you actually lost $10 per hour or $30 on that service call.

Before you say, “That can’t happen in our company” take a good look and a pencil to your financial statement. Determine what your overhead cost per hour is for each of your departments. Even if you haven’t departmentalized, begin by looking at your total company overhead and hours. Divide your total overhead last year by the total number of productive hours (i.e. revenue generating hours). Use only the hours that your field employees actually worked for customers. Cleaning the shop, training hours, meeting hours, vacations, holidays, and sick days don’t count in this equation.

If you have departmentalized, then do the same calculation as described above except for the overhead for each department. You’re likely to find one department with a much lower overhead cost per hour than another. At this point, you know how little you can charge a customer in slower times of the year and still make a profit on an individual job.

The result can be very sobering. It’s common for me to find this number above $60 per hour in many companies I start working with. The idea is to identify it, get it down to a reasonable number and compete!

How do you get the overhead cost per hour down? By having as many revenue producing hours as possible. Sometimes it is a simple as sending the men to the jobs from their homes rather than coming to the shop. Other times it is streamlining dispatch, getting job material sheets so that materials can be pulled and the employees don’t spend time pulling their own jobs. Keeping the technicians and installers working on jobs rather than having them stop to go to a parts house. One of the best ways is to ask your employees. They know how they waste time. Many times you have to ask the office about the field and vice versa. They know. Implement their suggestions.

The comment, “I can’t do anything in slower times of the year” doesn’t fly either. I know a contractor who almost never lost money in the traditional slower months. I asked him how he achieved this profit since most contractors didn’t. His answer was that he had no choice. He didn’t have the cash saved in the beginning to lose money in any month. Then, as the business grew, it just became a habit. He was extremely proactive in slower months, knocking on doors, calling customers and offering specials. Since he knew what his overhead cost per hour was and what revenues he needed to generate each month, he knew what lower price he could offer a customer for purchasing “now” rather than when the company got busy.

Relying only on gross margins to determine whether a job went well or not is dangerous. You have to know and understand what your gross profit per hour and overhead cost per hour are. The only thing that really counts is the net profit per hour that you are generating. That’s what you can convert to cash and take to the bank.

By: Ruth King

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