Dr. is In: The Secret to Charting New Waters Part II
In the September issue, our discussion on paralellism began with a review of gross margin. Part 2 focuses on how to be more efficient with your books to achieve maximum profitability.
If you are having trouble marking up your equipment by 50 percent to achieve the target 35 percent+ margin, you might be wondering where other profitable companies are making their money. The clear answer is that there is additional profitability hidden in the labor component of the jobs. Either these profitable companies have a higher billing rate, or are more efficient with their labor dollars. I think the answer is both of the above. Both additional margin in labor and efficient labor production must be present for companies to continue to be profitable in this market.
Are your books set up in a way to measure gross margin easily on each job? Even more important, are your books set up to measure the gross margin on each cost type? Can you easily determine the margin achieved on equipment sales versus that achieved from labor revenue? I recommend you create parallelism in your Chart of Accounts in order to track your income with the same detail that you track your Cost of Goods Sold.
Without this detail, let’s see what we can learn from a standard Profit and Loss (P&L) statement. Here is a very simple Profit and Loss Statement, where all the income is lumped together.
From this statement, we can see that we have achieved a 35 percent gross margin. We can also see that our equipment costs represent about 62 percent of our costs ($600,000 ÷ $975,000) and labor represents 38 percent of our total costs ($35,000 ÷ $975,000). But we are not able to see how much of our sales came from equipment sales versus labor sales. It is only through examining our actual costs compared to our budgeted costs by line item that we can see if we are hitting our cost targets.
Instead, let’s look at a P&L that is set up using parallelism, where we break out our sales into the same categories that we use to break out our costs.
Now, we learn that even though we achieved a 35 percent overall gross margin, we actually achieved a 33 percent margin on equipment and a 38 percent margin on labor.
We can also see that the source of our sales is 60 percent equipment ($900,000 ÷ $1,500,000). This may look like many ESC’s P&L’s in previous years. However, what happens if you decide that you can’t sell enough jobs with a 50 percent markup on equipment and you reduce that markup? If you still want to maintain sales of $1.5 million, you’ll need to sell more labor. And if the markup on equipment falls, you’ll need to make more money on your labor as well. So, at this point, not only do you have to sell more labor, you have to find a way to increase the margin you earn on labor.
Let’s look at one more P&L; one where we sell the same amount of equipment ($600,000), but with a reduced markup. In this case we use a 33 percent markup to achieve a 25 percent margin on equipment.
We also increase the total labor sales to make sure we operate at the same total sales of $1.5 million. And we mark up up our labor enough to make sure we still achieve a total combined gross margin of 35 percent.
By creating a P&L with parallel categories, we can not only continue to measure our gross margin, but we can see the financial effects of changes in the equipment markup and labor billing rates.
So, as we approach new business models, perhaps selling different types of products and services, now is the time to change the structure of your accounts so that your P&L Statement can help you determine the success of charting these new waters.