DETERMINING the standard for profitability
Mar 1, 1999 12:00 PM,
After many years of being too busy, I decided it was time to get an annualmedical physical examination. Nothing was bothering me, but in the interestof safety, at the ripe old age of 44, it was time. The physical examprocess itself was relatively simple, painless and enlightening. After aseries of blood tests, an EKG and a quick look over, the doctor said that Iwas in great shape. Of course, I wanted to know how he knew. He then showedme the quantitative results from the tests.
There were two things I learned from my medical exam. First, all signsindicate that I am in good shape. The second, equally important thing Ilearned was that it is relatively easy to judge someone’s medical conditionbecause of analytical tests and established standards for measuring health.Unfortunately, when it comes to measuring the health of low-voltagecontractors and service providers, similar standards are infrequent ormisunderstood. 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 paytheir bills and who is leaving whom. Most of what you hear you can takewith a grain of salt.
Then, you meet a colleague or peer who asks quite bluntly how your companyis doing. Your first answer is that with the Y2K upgrades, you have grownby 25% this year. Then, with your ego feathers fully displayed, you informhim that your revenues are now up to $5 million. The recipient of thisconversation is usually impressed and later, perhaps even envious. Thisinteraction is typical at most business events, and it adheres to a singleprinciple, namely bigger is better.
Although it is great to experience growth in your top line (revenue), mostof 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, themain 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 thatboast big revenues only to find out that the profitability of theircompanies is actually embarrassingly low. Even if you dare ask someone theright question with regards to profitability, you will more than likelyreceive an incorrect answer not because the provider of information isbeing deceitful (although he could be), but because the standards formeasuring profitability for low-voltage integrators (LVIs) is, unlike thecholoesterol test, not uniformly applied or defined.
The profit standard for LVIsThere are dozens of different types of standards-the double standard, thegold standard, and in Kohler, WI, the American Standard. When it comes tomeasuring and comparing profitability for LVIs, however, the picturebecomes cloudy. How can this be? Shouldn’t measuring the profitability fromone company be the same as the profit from another? Not really. That isbecause most companies differ in the way they define gross margin andallocate costs. To identify profitability accurately, you first need todefine gross margin. For most of us, the simple way of defining grossmargin 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 andrequired to complete a defined task or project. Some direct costs areobvious, 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-relatedtravel, engineering and project management, to name a few. Taking thenecessary effort to separate direct from indirect costs as well asinvesting the time and resources into a versatile job-costing system is thefirst major step to measuring your profitability accurately.
To determine where your gross margin and profitability should be, defineyour business. If you are primarily an equipment (box) house, then you canafford to have a lower gross margin because overhead will be relativelylow. On the other hand, if the majority of your business is as an LVI, theequation changes. Systems work requires a larger technical infrastructure,overhead and more capital. These additional requirements mean that grossmargins must also be considerably higher to be profitable.
If the majority of your business is systems work, then your real grossmargin (“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 marginbetween 20% and 35%, which is not enough to generate the necessary capitalto reinvest in equipment, trucks and other necessities associated withgrowth.
Is it possible to have a gross margin at 48% or higher? Absolutely. It is amatter of expectations and corporate positioning. At my former company, anLVI, 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 inthe country. It was not magic; we just focused on ways to increaseprofitability, many of which will be discussed in future articles.
So, the next time someone tries to impress you at a party with hiscompany’s size, ask about his real gross margin. Then, tell them your grossmargin is 45%. The silence will be deafening. Size does matter.