Tracking and Accounting for Commercial Maintenance Agreements
Originally published: 03.01.13 by Ruth King
Full maintenance and planned maintenance agreements need different treatment.
Editor’s Note: This is the second in a three-part series on accounting for maintenance agreements. In the February column, Ruth addressed accounting for residential maintenance agreements, and in April, she’ll address tracking of the value of maintenance agreements.
Accounting for commercial maintenance agreements is performed differently depending on the type of agreement sold and how that agreement is billed. I’ll cover full maintenance agreement accounting and planned maintenance agreement accounting separately.
First, full maintenance agreements, i.e., those agreements that cover all maintenance and service for your customer’s equipment for a period of time. The customer pays a specific amount each month, each quarter, or each year, depending on the size of the agreement. My rule of thumb is for agreements that are greater than $3,000 per year, you can bill monthly. For those agreements under $1,000 per year, the entire amount should be paid at the time the agreement is sold. Between $1,000 and $3,000 per year, you can bill quarterly.
The accurate method to account for these types of commercial agreements is to treat them like a job. You recognize the revenue at the end of the job. In between you
Reality? Unless you are a mechanical contractor that has already set up work-in-process, overbillings, and underbillings; and you are used to this accounting method, you aren’t going to invest the time to account for the agreements in this manner. My suggestion for most contractors is to recognize the revenue as you perform the maintenance. So, if you bill monthly, then you put all the monthly payments in deferred income. Then, when you perform the maintenance, take a quarter of the contract price out of deferred income and put it into sales.
Unless you have a service catastrophe, by using this method you will avoid financial fruit salad. This happens when revenues are in one month (apples) and expenses incurred producing those revenues are in another month (oranges). So your margins for this contract will be fairly consistent.
At the end of the contract year, create a P&L statement for this contract. If it is a multiyear full maintenance contract, there may be some years where you didn’t earn a profit because of service work and others where you did. Looking at the life of the contract, did you earn a profit? Did you break even? If you didn’t at least break even, you must increase the price or drop the contract to a planned service maintenance contract.
The second type of agreements, planned service maintenance, cover maintenance only. Any repairs or replacements are billed to the customer.
Many contractors bill for maintenance as maintenance is performed. In this case, there is no deferred income because there are no up-front payments. The company is being paid as the work is performed. You can accurately see the gross margins for the maintenance being performed.
Customer invoices must go out the same month that maintenance is performed. If you get behind and send the bills even though the work has not been performed, you’ll end up with financial statement fruit salad. You won’t know whether the monthly maintenance is profitable, breaks even, or is performed at a loss.
For contractors that bill planned maintenance agreements monthly and perform the work quarterly, all invoices should go into deferred income as they do with full maintenance contracts. Recognize one quarter of the revenue in the month that your technicians perform the maintenance.
Whether you have full maintenance or planned maintenance contracts, review each contract at the end of its contract year—both internally and with your customer. Review it internally to see whether the contract made a profit or was a loss. If the contract was not at least break even, find out why.
If it was because the technicians stretched the time spent at the customer’s location because they didn’t have anything else to do, that is a management issue that must be addressed. If a reasonable amount of time was spent at the customer’s location, and the contract still lost money, the price of the contract needs to be increased.
I know many contractors who are afraid to raise prices. However, we are not a supermarket that has “loss leaders” to lure customers into the store and buy more than what is on sale. All maintenance must at least break even. If you have a loss, you are paying your customer to do their work. That isn’t logical.
When I start working with contractors, many times their commercial maintenance agreement pricing needs to be increased. My experience is that you will lose a few customers who care only about price. But, those customers with whom you have built a great relationship and see the value of what you provide, will understand the price increases and stay with your company.
Ruth King has over 25 years of experience in the hvacr industry and has worked with contractors, distributors, and manufacturers to help grow their companies and to become more profitable. She is president of HVAC Channel TV and holds a Class ll (unrestricted) contractors license in Georgia. Ruth has authored two books: The Ugly Truth about Small Business and The Ugly Truth about Managing People. Contact Ruth at email@example.com or 770-729-0258.
Articles by Ruth King
Understand Your P&L Statement: Gross Margin, pt. 2
Gross margin should not vary more than a few points each month. If it does, then you must find out why the margin is varying.
Understand Your P&L Statement: Gross Margin
Understand Your P&L Statement: Cost of Goods Sold
However you decide to categorize expenses in your P&L, it's important to be consistent.
Understand Your P&L Statement: Sales vs. Revenue
Sales are critical to survival — when revenue is actually generated is even more critical.
The 20 Percent Profit Myth
For a realistic goal, include owners’ compensation in the net profit equation.