DETERMINING the standard for profitability
Mar 1, 1999 12:00 PM, Alan Kruglak
After many years of being too busy, I decided it was time to get an annual medical physical examination. Nothing was bothering me, but in the interest of safety, at the ripe old age of 44, it was time. The physical exam process itself was relatively simple, painless and enlightening. After a series of blood tests, an EKG and a quick look over, the doctor said that I was in great shape. Of course, I wanted to know how he knew. He then showed me the quantitative results from the tests.
There were two things I learned from my medical exam. First, all signs indicate that I am in good shape. The second, equally important thing I learned was that it is relatively easy to judge someone's medical condition because of analytical tests and established standards for measuring health. Unfortunately, when it comes to measuring the health of low-voltage contractors and service providers, similar standards are infrequent or misunderstood. Let me tell you what I mean.
Think about attending an industry event, like a trade show or conference. Rumors and innuendoes fly across the room. People tell you who cannot pay their bills and who is leaving whom. Most of what you hear you can take with a grain of salt.
Then, you meet a colleague or peer who asks quite bluntly how your company is doing. Your first answer is that with the Y2K upgrades, you have grown by 25% this year. Then, with your ego feathers fully displayed, you inform him that your revenues are now up to $5 million. The recipient of this conversation is usually impressed and later, perhaps even envious. This interaction is typical at most business events, and it adheres to a single principle, namely bigger is better.
Although it is great to experience growth in your top line (revenue), most of us are misled about how well we are doing by asking the wrong question. When it comes to being judged by the business community as a whole, the main question that really strikes home is not how big your revenues are, but how big your bottom line is. I know dozens of over-inflated egos that boast big revenues only to find out that the profitability of their companies is actually embarrassingly low. Even if you dare ask someone the right question with regards to profitability, you will more than likely receive an incorrect answer not because the provider of information is being deceitful (although he could be), but because the standards for measuring profitability for low-voltage integrators (LVIs) is, unlike the choloesterol test, not uniformly applied or defined.
The profit standard for LVIs There are dozens of different types of standards-the double standard, the gold standard, and in Kohler, WI, the American Standard. When it comes to measuring and comparing profitability for LVIs, however, the picture becomes cloudy. How can this be? Shouldn't measuring the profitability from one company be the same as the profit from another? Not really. That is because most companies differ in the way they define gross margin and allocate costs. To identify profitability accurately, you first need to define gross margin. For most of us, the simple way of defining gross margin is selling price minus direct costs (S - D = G).
The problem arises in defining direct costs. From a strict accounting view, direct costs are all of those costs specifically associated with and required to complete a defined task or project. Some direct costs are obvious, such as materials and installation labor. In many cases, however, other direct costs are left out of the equation and thrown into overhead. Some of these direct costs include freight, warranty, project-related travel, engineering and project management, to name a few. Taking the necessary effort to separate direct from indirect costs as well as investing the time and resources into a versatile job-costing system is the first major step to measuring your profitability accurately.
To determine where your gross margin and profitability should be, define your business. If you are primarily an equipment (box) house, then you can afford to have a lower gross margin because overhead will be relatively low. On the other hand, if the majority of your business is as an LVI, the equation changes. Systems work requires a larger technical infrastructure, overhead and more capital. These additional requirements mean that gross margins must also be considerably higher to be profitable.
If the majority of your business is systems work, then your real gross margin ("real" defined as a gross margin that includes all direct costs) should be at a minimum of 35% with a goal to be at 45% and above. Unfortunately, between 60% to 70% of LVIs are operating with a gross margin between 20% and 35%, which is not enough to generate the necessary capital to reinvest in equipment, trucks and other necessities associated with growth.
Is it possible to have a gross margin at 48% or higher? Absolutely. It is a matter of expectations and corporate positioning. At my former company, an LVI, our gross margins were 54%; we direct-costed everything to a project, and we were also in Washington D.C., one of the most competitive markets in the country. It was not magic; we just focused on ways to increase profitability, many of which will be discussed in future articles.
So, the next time someone tries to impress you at a party with his company's size, ask about his real gross margin. Then, tell them your gross margin is 45%. The silence will be deafening. Size does matter.
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