Once upon a time, there was a man who had worked in the HVAC industry for almost 20 years. He thought he knew just about everything a person could know about the HVAC business, so he decided to start his own business.
He worked very hard, sold lots of jobs, had a good business location, and had great employees who provided outstanding service and quality installations, and he was nearly bankrupt after only three and a half years.
That man was me! I wasn’t making any money because I priced every job incorrectly. I used the wrong basis of accounting. I didn’t know my overhead, I didn’t track job costs, I didn’t track labor, I had no clue about accounting, and most of all, I didn’t realize I was running three different businesses at the same time. Before it was too late, I attended some business management workshops, and learned how to departmentalize my business, and how to calculate correct selling price. I gradually crawled out of the financial hole I was in, and built a very profitable small business, which I eventually sold.
If you own an HVAC company, you’re also running many businesses, which may include residential new construction; residential replacement; HVAC service; commercial service; commercial new construction; and duct cleaning.
Ask yourself the following questions:
- Do you know your sales in each department?
- Do you know the “cost of sales” for each department?
- Do you know the gross profit/gross margin percentage for each department?
- Do you know your overhead expenses for each department?
- Do you know your net profit for each department?
If you answered yes to any of those questions, you may very well be a “Five Percenter.” The “Five Percenters” are those contractors who earn between 10% and 25% net profit before taxes.
If you answered no to one or more of those questions, you may be running your company by the “seat of your pants” method.
My guess is that 90% or more contractors do not departmentalize. That leaves about 10% or less in the entire HVAC industry that really know how to price correctly. We don’t departmentalize because, either we don’t know how or we don’t realize just how necessary departmentalization is when calculating your selling price.
If you don’t learn your overhead by department, then you’ll be doomed forever to have the competition setting your price! You must know the overhead in each of those businesses.
Importance of Gross Margin
If you’re going to show a profit, your gross profit dollars must be larger than your overhead dollars. That’s Business 101. When you sell a job, you must have larger gross margin dollars than overhead dollars in that department.
The gross margin percentage is the most important percentage in a business. Simply put, the gross margin must be larger than the overhead percentage or you’ll lose money! Therefore, if you know your overhead in each department, then all you have to do is generate enough gross margin to cover the overhead and any profit you want to make!
How do you price a job? The three best methods are the divisor method, dual overhead, or labor only recovery method.
The divisor method for this exercise, and from my experience, this method works very well in residential jobs 80 to 90% of the time. The dual overhead method is an alternative method that is a more accurate method, and is particularly important when you have a high direct labor cost to material cost. The labor only recovery method is used for the same reason.
Whichever method you use, you must know your overhead by department.
Departmentalization is the Key
Because I didn’t departmentalize, I had no clue what my sales were, or which department was making or losing money.
Each time you make a sale, it should be coded as service, replacement, new construction, etc. You should also know cost per sale.That’s the equipment you buy, and everything that goes into installing the HVAC equipment.
The overhead in a typical replacement department is between 30-40%. In a typical service department, the overhead is between 50-60%.
If you don’t know your overhead by department, how can you calculate the correct selling price?
How Direct Labor Method Works
First, assign a percentage of the direct labor that each employee spends in each department. A direct labor employee is an employee that works to repair or replace equipment.
For example: the service technician may spend 65% of his time doing service, 17.5% doing start-ups in new construction, and 17.5% installing replacements. You must repeat this exercise (assigning a percentage to departments) with all direct labor employees.
Once this is done, each department will have a dollar value of direct labor.
Divide total labor dollars in each department by total of all direct labor, for a percentage you can apply to all overhead items. There are a few exceptions, but it’s a simple, yet accurate way to departmentalize.
Who Prices Your Jobs?
The average net profit for our industry is, by some estimates, as low as 2.5%, or as high as 3.5%. The average salary for contractor/owners is about $36,500 per year. It was recently reported that, among businesses doing about $750,000 per year, the owners’ salaries averaged $40,000 per year.
To price a job correctly, you must know “cost of sales,” which includes equipment, materials, direct labor, subs, warranty reserve, and permits. (See Table 1).
| TABLE 1 If the cost of a sale is $3,906, and your A. 28% + 8% = 36% Proof: |
How to Departmentalize
- The service technician may spend 65% of his time doing service, 10% doing start-ups, and 25% doing replacements. You must do this percentage estimate with all of your direct labor employees.
- Add up all the annual direct labor dollars for each department.
- Add up the total of all departments direct labor dollars.
- Divide the total direct labor dollars into each department’s total. This will give you a department percentage of direct labor.
- Multiply each overhead expense (rent, insurance, utilities, etc.) by the department percentage.
| TABLE 2 Using the “divisor method,” with the same “cost of sale” of $3,906: | |||
| Department | Resid. New Construction | Replacement | Service |
| Overhead Desired net profit Divisor Selling price Gross profit in $ Gross margin % Net profit $$ $ Net profit % | 26% 10% .64 $6,103 $2,197 36% $610 10% | 34% 10% .56 $6,975 $3,069 44% $696 10% | 53% 10% .37 $10,557 $6,654 63% $1,056 10% |
| (Same cost, but a different selling price) | |||
| Using the “divisor vs. mark-up multiplier” method, with the same “cost of sale” of $3,906 | |||
| Department | Resid. New Construction | Replacement | Service |
| Overhead Desired net profit Mark-up (cost) x (oh + dnp) Mark-up Multiplier Selling price (Divisor Method) Sale Price (Difference in Methods) | 26% 10% 1.36 $5,312 $6,103 $791 | 34% 10% 1.44 $5,625 $6,975 $1,350 | 53% 10% 1.63 $6,367 $10.557 $4,190 |
| (oh = overhead; dnp = desired net profit) | |||
How to Track Your Progress Daily
- Forecast the department overhead dollars that will be spent for the entire month.
- Record the gross margin dollars you expect to earn on each sale.
Example of Daily Tracking:
Department overhead for the month: $5,000
Sales: (assume entire job completed within period)
- Bob the Builder – $7,000 job @ 33% gross margin = $2,310
- Smith Construction – $6,000 job @ 25% gross margin = $1,500
- Grandy Construction – $3,000 job @ 38% gross margin = $1,140
- Total gross profit dollars earned for period = $4,950
- Condition of department at end of month for the period = $50
- The department is short by $50.
To show a profit, you must earn enough gross profit dollars to exceed overhead dollars. In other words, the gross margin percentage must be greater than the overhead percentage.
Bill Ligon is president of Ligon Consulting, Hot Springs Village, AK, an HVAC consulting firm. Based on his experience as an HVAC business owner, he has developed a “Profit Forecaster” software program, to simplify job pricing and departmentalizing an HVAC business. He can be reached at 888/320-9220.