How Much Profit Should A Company Make?
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The question that often comes up is, “How much profit should a company make?” The answer to that question can be a bit confusing. It’s confusing because if you look at most of the published numbers, they all pretty much say the same thing. The average trades company makes a 3 to 5 percent net profit. Is that a good number? Absolutely not! The problem lies with our friendly accountant whose job it is to minimize the taxes the company pays. Let’s say the company has a review with their accountant in mid-December. After reviewing the numbers, the accountant estimates the company will finish the year with an 18 percent net profit. The company is going to have to pay a lot of taxes on that 18 percent. The accountant then suggests the company might want to prepay bills that will be due after the first of the next year or perhaps purchase another piece of equipment or vehicle and take the normal, or accelerated, depreciation. The accountant may even suggest loading up on inventory, or pre-purchasing quantities of materials, parts, or even equipment. Bottom line, the accountant wants to spend some of the earned profit now to reduce profit and therefore the amount of taxes the company will likely need to pay later.
This process is all well and good from the accountant’s standpoint because it works and taxes are reduced. The potential problem is spending too much cash. Most trade companies have slow seasons which often take place on the first of the year. It’s not unusual for a company to lose money in the first quarter before sales pick up as spring and summer roll around. If too much of the company’s cash is spent to reduce taxes, they can easily find themselves in a cash flow crunch during those negative months. Remember, there is a huge difference between accounting dollars and actual cash flow dollars. Cash flow deals with the real dollars that are flowing in, and out, of the company. Not having enough cash to fund short-term cash flow problems will result in the company having to take out a loan, use credit cards, or create, and draw upon, a line of credit. The answer is seldom 100 percent cash flow nor is it 100 percent the accountant’s suggestions. It’s usually somewhere in between.
Now, perhaps, you might have a better understanding of why the average trade company does not make a 3 to 5 percent net profit. It is normally much higher than that if it’s well run, but by the time the accountant completes their work, the end result shows, for tax purposes, a 3 or 4 percent net profit.
Now let’s go back to the original question. How much profit should a company make? The simple answer to that question is that a well-run company should generate a 10 to 12 percent net profit, overall. The key word is “overall.” Most companies have several departments ranging from residential service to huge commercial building projects. The projected profit varies widely by department and by type of work performed.
Generally speaking, the repair/service department should have the highest net profit. It also happens to have the highest overhead and is the most difficult to run properly! A well-run service department should generate a 15 to 20 percent net profit. If the service department is on flat-rate pricing, that number can easily jump to 20 to 25 percent net profit.
When it comes to the replacement of equipment, net profit should run 10 to 12 percent. Large commercial jobs, on the other hand, generally represent huge gross dollars while generating very small net profit numbers. Large jobs often run in the 3 to 5 percent range when it comes to net profit.
The final area is new home construction. You may remember earlier articles where we talked about how most companies got started. Many startup companies begin by doing new home construction work be it plumbing, heating, electrical, or any of a variety of trades. There are reasons for starting out doing this type of work. Builders are normally looking for the least expensive subcontractor. That would be our startup company! The new entrepreneur is often working alone or with one or two other people. Overhead is low because they are likely working out of their house or garage. With little overhead to cover, pricing can be lower (which is what most home builders are looking for) while still generating a profit. However, when those same companies begin to grow, they often move away from new construction work because their overhead goes up and their profit margins shrink. Bottom line, if you can make any money doing new construction work, congratulations.
The above was a broad stroke in terms of profitability by type of work. There are exceptions in every area. Companies that tend to focus on one, or perhaps two, areas tend to become very efficient at what they do and can easily exceed the above numbers. Other companies only do custom work for high-end customers. In that case, profit margins will also continue to increase. Even companies that do solely new construction can prosper. Companies that do only new construction tend to have their trade, policies, and procedures down to a science. They are efficient at what they do and know how and when to buy materials at discounted prices and they handle their cash flow well.
Back in 1987, during my first year in business, I was reading an article on an airplane. The article was about a small company that manufactured custom-made tennis shoes. This was well before the massive number of different shoe styles we have today, with unbelievable prices. This was back when a normal pair of high-top or low-top tennis shoes would cost the average consumer $12 to $15 a pair. For the benefit of younger people reading this article, tennis shoes back then only came in black or white! While the rest of the world was selling tennis shoes for $12 to $15 a pair, this guy was producing custom-made tennis shoes and selling them for $150/pair. I will never forget the last statement in his article. It said, “It really doesn’t matter what you do, or what you sell, as long as you are the best at what you do you will be successful.”
That’s the key. Pick an area of expertise and become the best at it in your area.
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Posted In: ACCA Now, Business Development, Management, Money
