A Workable Business Model Is Essential

March 11, 2004
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[Editor's note: This is the second installment of an eight-part series on business management by Mark Roberts, who details the lessons he learned as a result of placing his HVACR business into Chapter 7 bankruptcy liquidation. His goal: to prevent other business owners from going through the same ordeal. Here, Roberts points to the importance of financial planning in helping a company achieve its financial goals.]

An overall financial plan should be an integral part of your business strategy. I will not visit in depth how to price individual services or how to manage company operations, as these subjects are easily found in several other sources. I will, however, lay out the keys to creating an overall financial plan to guide you in developing your business success strategy.

In the first installment of this series ("Lessons Learned in Bankruptcy," March 8, 2004), "strategy" was defined as "managing sales, expenses and assets in such a way that your company achieves its financial goals."

I will now utilize return on investment (ROI) to help you create a strategic plan for your company. This is done by breaking ROI down into component parts so that sales, expenses, and assets can be structured to create a working strategic plan that is right for your business.

ROI can be broken down as shown in Figure 1.

Figure 1. Formulas for calculating return on investment.

Hypothetical Example

Let's look at an example. Let's assume an HVAC company has the following statistics:

  • Annual sales: $800,000.

  • Average total assets: $200,000.

  • Operating income: $32,000 (4 percent of sales).

    Allow our hypothetical company to reflect the following scenario: The company sells standard equipment and services a range of three counties, covering an area with a 50-mile radius from company operations. It does not provide much technician training and receives a high percentage of customer callbacks. The company uses the least-expensive equipment and supplies available, which sometimes results in warranty service calls. The company does not maintain tight controls over truck stock and shop inventories, and it lacks real job oversight and pre-job planning, resulting in lengthy job turnover.

    This company's ROI would equal 16 percent. (See Figure 2.) This could be considered a poor rate of return on the company's investment dollars, considering the risks of owning a small business. Unfortunately, this is also the average ROI for many companies operating in the HVAC industry.

    Figure 2. Determining the company’s return on investment in the first example. Here, the ROI is 16 percent.

    A Different Scenario

    Now let us consider another scenario. Under this scenario, the company practices strategic execution effectively, raising annual sales to $1 million. The company's selling methods are comfort-solutions based, resulting in more sales and more profitable selling prices. The company sells higher-value comfort equipment, such as variable-speed, two-stage furnaces. This allows the company to charge a higher price, if only based upon the higher markup cost of the equipment being sold.

    The company's service range was reduced to a 25-mile radius from company operations, allowing for one extra service call per day per technician. Project management improved, and with it so did job turnover. This allowed for a greater number of jobs to be invoiced over the course of the year.

    In this scenario, year-end sales dollars increased $200,000 (from $800,000 to $1 million). The company's average total assets remain at $200,000.

    Controls were implemented and shop inventory was monitored. Low-turnover inventory item purchases were reduced, resulting in a higher turnover of inventory on hand.

    Truck stock was monitored so that overstocking and waste were reduced, and the tighter service range allowed more work to be done with the same amount of vehicles.

    Accounts receivable controls were put in place, resulting in better cash flow and less receivables outstanding. However, since the company grew in sales, accounts receivable in dollar terms remained unchanged.

    In this scenario, operating income is $60,000, or 6 percent of sales. Notice that net income increased by only 2 percent of sales when compared to the first scenario. The 2-percent increase in profit was due to the higher job turnover, higher daily invoicing under a tighter travel range, and increased dollar profits through solution and value-based selling, reduced warranty work due to the use of better-quality equipment and supplies, and callback labor was down.

    Figure 3. In the second scenario, the company’s ROI increases to 30 percent.
    An increase of only 2 percent of sales was due to additional overhead dollars that were spent on technician training, local marketing to increase sales under a tighter service range, and slightly higher equipment and supply costs.

    What do these changes mean for the company's ROI? Let's take a look at the calculations shown in Figure 3.

    As you can see, the company's rate of return nearly doubled, jumping from 16 percent to 30 percent. Now you are beginning to see how managing your company's sales, assets, and expenses in a strategic way can help you to achieve your company's financial goals. This is how successful business owners create personal wealth.

    You can play with this equation utilizing a multitude of scenarios to devise a business model that is right for your company. The key is to balance your profits and asset utilization in such a way that you maximize your company's growth while earning a return on investment that is equal to or better than your company's costs of financing and alternative investments with similar risks.

    Turnover And Profit

    Have you ever wondered why vendors who always seem to have the parts that you can't seem to find anywhere else also seem to charge a higher price? The answer for their higher prices can be found in the ROI equation. These vendors have to carry a greater inventory on their shelves, which increases their assets on hand. Since those hard-to-find parts don't sell as quickly as more commonly requested parts, these vendors do not turn over their assets as quickly as the vendors who only stock high-demand parts do. If vendors who stock these hard-to-find parts are going to meet their ROI requirements, they must receive a higher profit on the units that they sell. That is, lower asset turnover necessitates a higher operating profit to meet the same ROI. (See Figure 1.)

    As I previously indicated, sometimes a higher profit on your in-come statement may not be in your company's best interest. The reason is that higher profits might stifle sales growth and actually reduce your ROI. In the example above, the company earned an ROI of 30 percent. But let's assume that the reasons for your company's higher profit margins are due to higher selling prices rather than more efficient management of your company's operations. (I am not implying that you do not maintain a higher selling price than your competitors; I am implying that if your price is higher, you must provide a perceived value for the price, or you may not close as many sales as you otherwise could.)

    Figure 4. In this example, return on investment drops to 24 percent as a result of higher selling prices.
    Higher selling prices might result in a higher operating income but a lower sales closing rate. The end result could look like the example in Figure 4.

    While operating income rose an additional 2 percent of sales (to 8 percent), the company's asset turnover fell from 5x to 3x. This incurs a lower return on investment for the company, even though operating income, as a percentage of sales, was actually higher than in the previous example.

    Figure 5. This chart details the relationship between operating profit and asset turnover.
    Ideally, you want your company to maximize its sales potential, resulting in a higher asset turn-over, and efficiently manage operations, resulting in a higher operating income, thereby increasing ROI. An asset turnover of 5x coupled with an operating income of 20 percent would yield a staggering 100-percent return on the company's investment in one year.

    A word of caution: When putting together your strategic plan, you should have a realistic idea of what sales your company can achieve utilizing the assets it has on hand. This is known as "sales capacity." Preparing a strategic plan with unrealistic sales goals could result in your company failing to meet its ROI goals. As a guide, asset turnover (annual sales divided by average total assets) averages between 3x to 6x in the HVAC contracting industry.

    Next week: Long-term cash flow can be difficult to forecast, but figuring out the minimum amount of cash your company should have on hand to maintain operations can save your business.

    Roberts is owner of Roberts Commercial Lending Co. LLC. He provides corporate finance and debt consulting, business loans, and leasing services. He can be reached at 586-716-8329 or CommercialFnnc@aol.com.

    Publication date: 03/15/2004

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