Have You Played The “What If?” Game?
The “what if” game can be very revealing and profitable! Before considering playing the game it would be very helpful to fully understand the three main reasons companies go out of business.
- 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.
- Cash Flow – Cash flow is the number two killer of small businesses. 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.
- One Department Subsidizing Another – This is often a major issue with older companies that offer several products and/or services. Few companies, actually less than five percent, break their costs out, by department, all the way through the P/L including fixed and variable overhead.
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 guess what, you can model your company, by department, manually, but it’s a lot easier to play the “what if” game if you have a modeling software program. Now to save time let’s assume you have created a month-by-month, department-by-department cash flow budget either manually, or using our 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, 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 two companies I have worked with to illustrate how it works.
This company did about $1.5 million in gross sales. Roughly a million dollars was generated by the commercial division with the remaining dollars being generated by residential service, which was, by the way, 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 final “what if” involved totally eliminating the commercial division, shifting fixed overhead to service and then 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. By 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’s” clarified the needed changes to increase profitability while eliminating the normal headaches of commercial work along with its resulting cash flow issues.
This $24 million company had a $12 million mechanical division and a $12 million service division at two 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 responding overhead, by about $4 million 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 final 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 million, BUT the resulting overall net profit was $2.5 million. Again, the “what ifs” clearly defined the direction the company needed to go in.
Keep in mind the most profitable companies 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.
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Posted In: ACCA Now, Management, Money
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