Know Your True Costs

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By: Ruth King


When you understand and track all of your costs you can make decisions about whether the costs are too high, acceptable or too low.  If a cost is too high or too low, determine why.  You might have estimated incorrectly or there is a problem that must be resolved.

There are four types of cost:

  • Direct
  • Indirect
  • Tangible
  • Intangible

Direct costs are those costs you incur because you sold something.  If you don’t sell, you don’t incur these costs.  Direct costs usually include labor used to produce jobs, equipment, materials, commissions and SPIFFs, warranty, freight, subcontractors, union dues, and permits.

Labor cost can be tricky.  Only the job labor goes in direct cost.  Vacations, holidays, meeting time, and other unapplied time is an overhead expense.  You can’t bill for this time.  Yet, you pay the employees for it. Some contractors put payroll taxes for the field employees in direct cost.  It doesn’t matter where you put it.  (Other than being consistent from month to month, gross margin doesn’t matter – see last months’ column).

Commissions are always included in direct cost.  No sale.  No commission. If you pay a sales person a salary plus commission, that salary goes in overhead.

Indirect costs are all of the costs you incur to stay in business.  These include rent, utilities, office salaries, etc.  Look at the overhead cost list on your profit and loss statement to see all of them.

Tangible costs are costs that you can see.  These are the costs that you write checks for. They include the direct and indirect costs for your business.

Intangible costs are the most dangerous types of costs because they are “hidden” and can dramatically affect your profitability.  One of the typical intangible costs is sales cost.  Owners accept a lot of intangible sales cost.  If your sales person’s closing ratio is 25%, he is “burning” 3 out of 4 leads.  How much do those leads cost?  Is burning 3 out of 4 acceptable?

Lead cost includes all marketing and advertising, including referrals, web costs, social media costs, and traditional advertising costs such as radio, television, and newspaper. Track the number of leads generated from these types of media.  It’s as simple as asking, “How did you hear about us?” when a new customer calls or “What prompted you to call us today?” for a customer in your data base.  Most software packages can track this for you.  It’s as simple as putting in the data.

Look at sales closing rate from a profitability perspective.  Assume your average sale is $10,000,  your desired net profit per hour is $100, and it takes 2 men 8 hours to install a residential system.  That generates $1,600 net profit for each job (16 hours times $100 per hour).  If your sales person is given 500 leads a year (10 leads a week for 50 weeks), his closing ratio increases from 125 closed jobs to 250 closed jobs. This generates an additional $200,000 in profit ($1,600 times an additional 125 jobs).  What amount of intangible lead cost are you willing to accept?

The other major intangible costs are warranty and call back expenses.  Even if you expense a small percentage of material cost for every job and put it on the balance sheet as accrued warranty expenses to cover the inevitable warranty costs, the amount on your balance sheet is not your true warranty cost.

When a warranty call or call back occurs, the technician’s time and part cost is usually transferred to the service department to cover that cost.  However, most contractors only cover the direct cost.  Some cover the overhead cost per hour too.  None that I know will let the service department get a profit on warranty expense.  As a result, the department loses the amount of profit they could have generated for a “real” service call.

When you bill a manufacturer, they give you a labor rate which never covers all of your intangible costs.  The most expensive is lost revenue opportunity cost. Not only do you have expense of paying for the technician’s time, truck and overhead expenses, you cannot generate revenue during that call.  If a technician takes two hours to perform that warranty call, that is two hours that he cannot generate revenue.  If your average service ticket revenue is $250, then you’ve lost the ability to generate $500. Add the lost opportunity cost to the warranty expense.

The most expensive call backs are stupid mistakes – leaving a disconnect off, not putting a panel back on a unit, etc.  How many are you willing to accept before firing that employee?

Track all of your costs, tangible and intangible.  Then make sure they are what you’ve planned for your journey.  If not, take steps to correct the costs to get them back in line.

Ruth King is known globally as the “Profitability Master,” and is a a thought leader in entrepreneurship and business. Her books have been recognized as among the greatest in numerous industries. Learn more about all her business activities here

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