Understand Your P&L Statement: Gross Margin, pt. 2
Originally published: 06.01.15 by Ruth King
While gross profit can vary widely from month to month depending on how busy your company is, 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.
Remember, gross margin is defined as gross profit divided by sales. As I stated last month, there are seven major reasons your gross margins are not consistent. So far, I covered the first three reasons:
- Financial statement fruit salad.
- Inventory counted as material expense.
- Jobs over or under n labor and/or materials.
Here are the final four reasons.
4. Callbacks and Warranty Expenses
You have expense with no revenues against those expenses. In the case of warranty, you may recover part of the expense when you submit warranty claims to suppliers. In the case of callbacks, you didn't do the job correctly the first time. This is costly in terms of profits and customer satisfaction.
If you have a warranty part then you have to make sure that the purchase of the replacement of that part is not an expense to the department. You've already expensed it once against the job, you can't have it expensed twice!
Warranty parts are not inventory. I have seen thousands of dollars just sitting in companies' warehouses where no one took the time to send back the parts. Or, they don't send the parts back in the proper time frame and miss the opportunity to receive credit for those parts. Or, they send them back and don't watch to see if they get the credits back. Warranty can make your direct expenses higher so that you will show a lower gross margin.
Callbacks are internal mistakes. Find out why they are happening and fix the problem. Most times it is a training issue. A technician doesn't know how to diagnose properly or an installation crew doesn't know how to install properly.
Make sure there is a installation check sheet that crews must complete. Even airline pilots do a check sheet every time before they take off. This prevents "forgetting about something important."
5. Paying Overtime and Charging Regular Time
Most residential maintenance agreement customers pay no overtime charges. In these cases, even if you are paying your technicians overtime you are charging the customer regular rates rather than overtime rates. You still have the same selling price to the customer. Margins are often lower by a percentage point or two in busy times of the year because of no overtime charges. You can be busy and be less profitable because your margins are lower!
6. Maintenance Agreement Sales and Expenses
If you account for a maintenance agreement sale when the sale is made rather than when the work is performed, in months that you have sales and no maintenance work, your margins will be higher.
In months where you perform a lot of maintenance you have no revenue and all of the labor and material expenses so your margins will be lower.
This is financial statement fruit salad for maintenance. Remember that when the sale is made your company has a liability until it performs the work. This liability goes on the balance sheet. Assuming that you perform two maintenance procedures per year, when you perform the first maintenance you account for half the sale and create a revenue for half the sale.
If you are noticing gross margins decreasing and none of the first six issues are present, then unfortunately you have No. 7.
Employees don't charge customers for materials they use on their service calls. Or line sets and other copper parts disappear. Or an employee picks up two motors instead of one needed for a job and keeps the second motor. Or, parts which should be on the truck are not on the truck.
Theft is usually discovered during inventory counts when the actual inventory is much less than what it is supposed to be based on the balance sheet value. Hopefully, this is not the case in your company.
Watch your gross margins each month. Ensure they stay consistent. If not, these seven frequent occurrences should give you where to look for the issues. Fix them so you can make great business decisions based on accurate financial data.
Ruth King is president of HVAC Channel TV and holds a Class II (unrestricted) contractors license in Georgia. She has more than 25 years of experience in the HVACR industry, working with contractors, distributors and manufacturers to help grow their companies and make them profitable. Contact her at firstname.lastname@example.org or call 770-729-0258.