Taking Care Of Business

January 16, 2006
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PITTSBURGH - Well, it wasn't sexy. Then again, before talking about financials, income statements, working capital, and other business and accounting measures, consultant Gary Oetker warned his contractor audience that his topic wouldn't be. After all, trying to help contractors build a solid financial base so a business not only stays in business but also progresses doesn't lend itself to being sexy.

"Do you have the money you need to pay your bills when you need to pay them?" asked Oetker, point blank. "It comes down to cash flow."

Over a day of intense talks, Oetker was "Taking Care Of Business," the title of his presentation at the Masters of the Game Conference.

FINANCIAL BASICS

Over the course of his session, Oetker provided accounting formulas to follow. For example, to determine gross profit, subtract revenue dollars (sales) minus direct costs (the cost of sales). The tricky part, he agreed, was factoring in all that makes up cost of sales. In his estimation, this includes parts/material, equipment, labor, subcontracting, permits, equipment rental, warranties, extended warranties, buy downs, rebates, allocated fringes, sales commissions, and sales salaries.

While some of these are conventional direct costs - such as parts/material, equipment, and labor - Oetker wanted to make sure that contractors factor in everything under these respective headings. For instance, he said a contractor should factor the cost of a warranty into every job - generally as a percentage of sales - since a contractor may have to attend to a warranty issue.

Consultant Gary Oetker believes that having a lack of working capital can create cash flow problems.
"Otherwise," he said, "the service department is subsidizing the installation department."

He noted that overhead is also generally associated with labor. When it comes to sales expenses, sales commission and sales salary should enter into the equation.

"Your gross margins should be 60 percent," he said. "Champions are built on a good defense, so we have to have a good base."

Having determined the gross profit of a business, it is possible to determine the operating profit, or earnings before interest (EBIT). In order to calculate EBIT, subtract the overhead (operating expenses) from the gross profit. When it comes to overhead, contractors need to examine marketing, employee-related expenses, plant and equipment expenses, vehicle-related expenses, and administrative costs.

Oetker encouraged each of the 50-plus Lennox dealers to departmentalize their respective businesses. In his estimation, separate evaluations keep each department accountable.

"This allows owners and general managers to evaluate department heads," he explained. "This also allows the owner or general manager to compensate for performances."

Departmentalization allows an owner or general manager to be aware of the company's business mix, as well as aids budgeting and forecasting practices.

"It's a tremendous aid in setting prices," said Oetker.

NEED FOR BALANCE SHEET

To address assets, subtract liabilities and net worth. Another way of providing this balance sheet is to subtract assets from liabilities to obtain the net worth. "You need to get this balance sheet together," he encouraged. "A balance sheet is a picture of your business financially at that moment."

According to Oetker, current asset accounts include cash, accounts receivable, notes receivable, inventory, work in process, prepaid expenses, and fixed assets. Fixed assets include property, plants, equipment, vehicles, and building leases. Place accounts payable information, notes payable, current portion of long-term debt, accrued expenditures, and reserve accounts, such as warranty and service agreements, under the current liabilities heading.

To determine working capital, subtract current assets from current liabilities. In Oetker's estimation, working capital should equal 10 percent to 15 percent of annual sales. In the end, he said that profits retained in a company provide the working capital needed for growth.

"A lack of working capital can create a cash flow problem," he said. "Proper pricing is the key to increasing working capital."

TOP 10 TIPS

Oetker said it's good to compare a company's performance against industry standards, or key performance indicators (KPIs). This process, otherwise referred to as "benchmarking," helps contractors evaluate operations, challenge the existing norms, identify the most important changes needing to be made, and focus a business on the right changes.

"It helps create validity to goals," explained Oetker.

By benchmarking, contractors can focus priorities on what they want changed, determine what they need to review, set goals, and create action plans for attaining these goals.

"Always look at KPIs in groups," he warned. "Never get too focused on a single number."

Oetker provided his top 10 business tips, which are:

1. Culture is based on ethics, excellence, and integrity.

2. All managers and employees should know and understand the business model used by the company.

3. All managers and employees should know and understand the numbers and KPIs.

4. A business should have a gross margin that is equal to or greater than 42 percent (specifically for a residential service, maintenance, and replacement company).

5. In regard to overhead, this should be equal to or less than 28 percent (again, for a residential service, maintenance, and replacement company).

6. All replacement jobs must be completed in one day.

7. Equipment costs should be less than 25 percent of the replacement sales.

8. Service and maintenance revenue should be equal to or greater than 25 percent of the total residential service, maintenance, and replacement revenue.

9. Revenue per employee should be equal to or greater than $120,000 (excluding all comfort advisors or salespeople) to the office ratio of 2.5 to 1 (again, specifically for a residential service, maintenance, and replacement company).

10. Maintenance agreements should be equal to or greater than $1,000 per $1 million of revenue (again, for a residential service, maintenance, and replacement company).

Aaron Price (far left), of Engel A/C, Quakertown, Pa., and Russ deFuria (far right), president of O’Brien Heating and Air Conditioning, Drexel Hill, Pa., look over the work sheet provided by consultant Gary Oetker.

FORMULAS TO WORK FROM

For residential replacement firms, Oetker provided his direct cost model. The ideal breakdown is: parts and material, 7 percent; labor, 8 percent; equipment, 24 percent; subcontracts, 0.3 percent; permits, 0.5 percent or less; extended warranty, 0.5 percent; buydowns, 1 percent; equipment rental, 0 percent; warranty, 0.5 percent; allocated fringe benefits, 3 percent to 4 percent; and sales salaries and commissions, 4 percent to 8 percent. The total cost of sales should be 48.8 percent to 53.8 percent, while the gross margin should be 51.2 percent to 46.2 percent.

The ideal breakdown for residential service firms is: parts/material, 13 percent; labor, 22 percent; equipment, 0 percent; subcontracts, 0 percent; permits, 0 percent; extended warranty, 0 percent; buydown, 0 percent; equipment rental, 0 percent; allocated fringe benefits, 7 percent; and sales salaries and commissions, 1 percent. The total cost of sales should be 43 percent, while the gross margin should be 57 percent.

And, the ideal breakdown for residential maintenance companies is: parts/materials, 6 percent; labor, 34 percent; equipment, 0 percent; subcontracts, 0 percent; permits, 0 percent; extended warranty, 0 percent; buyouts, 0 percent; equipment rental, 0 percent; warranty, 0 percent; allocated fringe benefits, 9 percent; sales commissions, 4 percent, and sales salaries, 0 percent. The total cost of sales should be 53 percent, while the gross margin should be 47 percent.

In addition to ideal business formulas to strive for, Oetker provided some KPIs, including:

  • In his estimation, the sales growth rate for an HVACR firm should be 15 percent.

  • A company should hold weekly operational meetings.

  • The minimum residential replacement gross profit dollars per man-day should be between $600 and $750.

  • The minimum residential revenue per installation technician per year should be $250.

  • Revenue per comfort advisor or salesperson should be a minimum of $750.

  • The closure rate for nonservice agreement sales leads should be 31 percent.

  • The first-time completion ratio should be at a 90-percent minimum.

  • Average revenue per call is $160, at a minimum.

  • The efficiency ratio should be 75 percent or higher.

  • At least 25 percent of demand service calls should be converted to service agreements.

  • Revenue per service vehicle should equate to $110,000 to $120,000 or more.

  • At least 31 percent of technicians should be certified by North American Technician Excellence (NATE).

  • Sixty-three percent or more of precision tuneups should be converted to service agreements.

  • There should be an 86 percent service agreement renewal rate.

  • Revenue per maintenance tech should be between $60,000 to $80,000.

    FOCUS ON PRICING

    Oetker did spend a large chunk of his presentation addressing pricing and pricing issues. According to him, pricing is part art and part science.

    "The art comes into determining how to communicate value and establishing a price point for the value you offer," he explained. "The science is the mathematical aspect in setting prices."

    He said value is created when "the perceived benefits exceed the belief in what those benefits should cost." In other words, perceived value ultimately determines price.

    "Value is part of the customer's belief system," said Oetker. "Value perception is highly personal. Value, in this case, is what the customer believes the benefits will do for them. In the end, value shifts with trust."

    To boost pricing, Oetker recommended boosting trust, which can be accomplished through company branding. A company demonstrates branding with business and marketing philosophies; warranties and guarantees; referrals; and how it portrays value.

    Contractors can demonstrate value through a company's image using customer communications and education, by way of the service/maintenance processes, and with internal marketing.

    Oetker provided his audience with several pricing methodologies, including:

  • Divisor pricing formula: Direct costs divided by (1 – desired gross margin percentage).

  • Breakeven pricing formula: Overhead divided by gross margin percentage.

    He zeroed in on residential replacement pricing, whereby a contractor could turn to an engineered-job or bid-and-spec approach versus cookbook or flat-rate pricing. He also talked about positioning pricing or the good-better-best sales approach.

    This is used to reflect more than just the price of equipment. It factors in equipment efficiency, comfort, indoor air quality, service agreements, warranties, and guarantees.

    Publication date: 01/16/2006

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