Have You Played The "What If" Game?
Tuesday, December 8, 2015
Playing the "what if" game for your business can be very revealing … and very profitable. “What if” we raised our prices? “What if” we added another tech? “What if” we upgraded our maintenance agreement plans?
Before considering playing the game, it would be helpful to fully understand the three main reasons most trades companies go out of business.
1. Improper Labor Pricing - The number one killer of small businesses involves not understanding how much the company needs to charge, in each department, to cover costs while generating a reasonable profit.
2. Poor Cash Flow Management - Even if a company is priced properly, in each department, it can still go out of business because of cash flow issues. Most trades companies are highly seasonable, with the end result being 2-4 months a year where the company loses money. The company may be profitable for the entire year, but if it can't cover short-term cash flow needs it can easily go out of business before those profitable months kick in.
3. One Department Subsidizing Another - This is often a major issue with older companies that offer several products and/or services. Very few companies -- less than five percent – break their costs out, by department, all the way through the P/L including fixed and variable overhead. Again, the end result is predictable. One department ends up subsidizing another one and no one knows it until it's too late!
The first step in avoiding all three of the above potential pitfalls is to model your company, by department. Have you ever tried playing checkers without a checkerboard? It can be done, but it's a lot easier if you have the game tucked away in your family room closet. Well, you can model your company manually by department, but it's a lot easier to play the "what if" game if you have intuitive software to help you do it (such as Grandy & Associates industry-acclaimed modeling software program, Labor Pricing for a Profit with Cash Flow Projections!). To save time, let's assume you have created a month-by-month, department-by-department cash flow budget either manually, or using modeling software.
You have entered the equipment replacement costs, direct and indirect labor, fixed and variable overhead, and materials, all by department. When completed, you will instantly know which departments are making money and which are not. You will also know if the overall company is making money and what your projected month-by-month cash flow looks like. This is not a simple process to complete but it can be very revealing.
When the initial model has been completed, the real fun begins. Now it's time to begin the "what if" process of changing things (add a tech, change an overhead cost, buy another piece of equipment, increase your material mark ups, etc.) to see how the proposed changes will affect your hourly rate, cash flow and overall profitability.
This process can pinpoint problems while clearly showing the company owner what changes need to be made to ensure future profitability. I want to share the summary results of three companies I have worked with over the past several months to illustrate how it works.
This company did about $1,500,000 in gross sales. Roughly a million dollars was generated by the commercial division, with the remaining dollars being generated by residential service (which, by the way, was on time and material pricing). The commercial division had a projected net profit of about $20,000, while the service division was generating about $35,000 in net profit. The "what if" involved totally eliminating the commercial division, shifting fixed overhead to service, and adopting flat-rate pricing within the service departments. In order for service to absorb the extra overhead, and generate a reasonable profit, the hourly rate needed to be raised by $30/hour. An increase of $30/hour will not even be noticed by the customer if you are on flat-rate pricing. Increasing the service hourly rate by about $30/hour and eliminating the commercial division resulted in nearly doubling the company’s overall net profit! Bingo, doing a few "what if" scenarios clarified the needed changes to increase profitability while eliminating the normal headaches of commercial work along with its resulting cash flow issues.
This $24,000,000 company had a $12,000,000 mechanical division and a $12,000,000 service division at two physical locations. When the initial model was completed, it revealed a loss of about $188,000 in the mechanical division. The first "what if" reduced the mechanical division, and corresponding overhead, by about $4,000,000 in gross sales. The loss in the mechanical division increased to about a half million dollars. That was not the answer. The second "what if" eliminated all mechanical work, and accompanying overhead, at the second location. That model revealed a loss of roughly $750,000. That was not a good option either. The finial model eliminated the entire mechanical division including support staff, techs and relevant fixed and variable overhead. That was a winner. Company gross sales were cut in half down to $12,000,000 BUT the resulting overall net profit was $2,500,000. Again, the "what if" clearly defined the direction the company needed to go.
This company grossed a little less than $2,000,000 and had two locations about 200 miles apart with nearly all support staff, in terms of paperwork, in one location. The company had four divisions with the initial model yielding roughly a break-even situation overall. However, since the company was modeled by department, it became obvious which departments were losing money and which were extremely profitable. The overall game plan involved keeping all departments, including the ones losing money. However, two things became apparent during the "what if" process in terms of the departments that were losing money. First, closing those departments altogether would only make things worse, since much of the fixed overhead would remain and would have to be moved to profitable departments, which could not support the increased overhead. Secondly, if small changes could be made in terms of increasing gross sales and improving productivity while making slight increases in pricing, the losing departments could become profitable within the next 6-12 months.
One department, at the second location, proved to be much more profitable, once the company was split into departments. The game plan at that location became obvious – grow the profitable department as fast as possible. The game plan to create growth was put into place. Assuming the overall objectives are accomplished, the company should become very profitable within the next year. Bingo, modeling the company, and doing the "what if" revealed a clear path toward profitability.
The most profitable companies within the trades industry are run by owners who understand the numbers. Modeling your company, either manually or using software, can be a tremendous aid in terms of setting the stage for profitable growth in the future.