Gross Margins and Net Profit Percentages Don’t Matter

I hear contractors brag about their bottom-line percentage or their gross margin percentage.  Neither of these percentages really matter.  What matters is the bottom-line dollars or that the gross margins are consistent.

Bottom-Line Percentages

Those who talk about bottom-line percentages turn those percentages into dollars in their minds.  What were the actual bottom-line dollars?  That’s what they really care about. They can’t take the percentage to the bank.  They can only take dollars to the bank.

Go one step further:  What was the actual net profit per billable hour?  This is the number that really matters. 

Net profit per hour is total net operating profit divided by billable hours.  It answers the question, for every billable hour, how much profit does the company earn?

Billable hours are just that – only hours that you can bill a customer.  They don’t include training hours, vacation hours, and unapplied time. 

Net profit per hour comparisons are the most accurate company comparisons.  When owner’s compensation is added back to net profit, then net profit per hour comparisons truly define which company is most profitable.

Let’s look at three companies:

	Revenue	Net Profit	Net Profit %	Billable Hours	Net Profit/Hr
Company A	$2,000,000	$200,000	10%	10,000	$20/hr
Company B	$2,000,000	$200,000	10%	8,000	$25/hr
Company C	$1,000,000	$100,000	10%	4,500	$22.22/hr

All three companies have the same net profit percentage.  Company B is the most profitable. It has the highest net profit per hour.  Company C with half the revenues as Company A, is more profitable than Company A.  The percentage doesn’t matter.  The net profit dollars do. 

What is your company’s net profit per hour?  If it is negative, the company paid its customers to do their work.  If it is lower than you’d like, then either increase revenues per ticket/job or decrease overhead cost per hour.

Gross Margin Percentages

Comparisons of gross margins among companies are unreliable.  Gross margin is defined as gross profit divided by sales.  Gross profit is revenue minus direct expenses or cost of goods sold (i.e. an expense you incur because you sold something). Gross margins vary widely depending on what expenses are put in direct cost and what expenses are put in overhead costs.  There are three major variables:  labor, sales person compensation, and truck expenses.

Labor expense is the greatest variable.  Contractors can include only the direct cost of labor to perform a job or provide service in cost of goods sold.  Or, they might put all labor expenses in cost of goods sold.  This includes vacation, holidays, meeting time, and non-billable time.  The next choice is to break out all unbillable or unapplied time and put it in overhead (including vacations, etc.)  The fourth choice is to include benefits in cost of goods sold including FICA, Medicare, worker’s compensation, etc. 

For union contractors, the choice is simple.  They must pay the benefits package for each hour worked.  All goes in cost of goods sold.

For non-union contractors, most do not include unbillable time or benefits in cost of goods sold.  This makes it easier to track direct cost and overhead costs.  Some contractors divide overhead costs into overhead compensation costs and other overhead.  All benefits and unbillable time go in overhead compensation costs. 

Sales person compensation is the second variable.  If a sales person is paid a salary plus commission, then the entire compensation can go in cost of goods sold or only the commission put in cost of goods sold.

Truck expense is the third variable. Some contractors put truck expenses in cost of goods sold.

Contractors who put all of the costs listed above in cost of goods sold, will have a lower gross margin than those contractors who only put hourly cost for installation or service and commissions in cost of goods sold.  They will also have a lower overhead cost than those companies who do not put all of the costs listed above in cost of goods sold.

If a contractor brags that their company’s gross margin is 60% then it is likely that only labor and material expenses are included in cost of goods sold. Another contractor might have a gross margin of 28%.  Without knowing what is included in cost of goods sold, it is impossible to accurately compare the profitability of each company.

The key is for gross margins to be consistent.  If they are consistent, owners know that their pricing and the costs to produce those sales are consistent.  They also know that the profit and loss statement is probably accurate with all revenues matching expenses incurred producing those revenues in one month.

If gross margins are negative, that means that the company purchased goods/labor and sold it for less than it purchased them for.  This isn’t likely. Usually when this occurs, revenues are in one month and the expenses incurred producing those revenues are put in another month. It is imperative to match revenues and expenses so owners can make sure pricing is correct.

Percentages don’t matter.  Dollars do. 

 

Ruth King is well known as “The Profitability Master.” She is passionate about helping small business owners get profitable and stay profitable. Ruth is a serial entrepreneur having owned 8 businesses in the past 37+ years. Since 1981, through her Business Ventures Corporation, she coaches, trains, and helps contractors and others achieve the business growth and goals they want to achieve. Learn more about Ruth at hvacchannel.tv and ruthkinghvac.com.