The Incredible Shrinking Bottom Line
By Bill Prosch
In a recent conversation with my colleagues, we discussed the idea that growth in business isn’t always represented by total sales. Clearly, there are cases where reducing our top-line revenue actually increases net profit. Let’s look at an example.
Incredibly Good Restoration (IGR) was purchased seven years ago by Ian Martin Boss (I M Boss). Mr. Boss transformed this mom-and-pop, mitigation-only company with revenues of $300,000 per year to a $700,000 mitigation-only powerhouse within two years. IGR was so efficient that customers and adjusters alike absolutely loved them.
In fact, these same customers and adjusters thought IGR was so good that they pushed and pushed Mr. Boss to move into reconstruction. After all, they were stellar performers in mitigation, so shouldn’t reconstruction be just as profitable? The money seemed promising, and it appeared to Mr. Boss that he could bring in twice as much in reconstruction income as he was in mitigation. There was just one small problem: Mr. Boss had never run a construction company.
Recognizing his apparent weakness, Mr. Boss hired Steve. Steve was well versed in running construction projects as he had been a foreman for a reputable builder in the area. Steve knew construction, but he was unfamiliar with mitigation and had no experience in restoration-style reconstruction. Steve also had never used restoration estimating software. But how hard could this stuff be to learn? After all, he was a construction expert.
IGR’s construction sales quickly surpassed mitigation by a factor of two, making combined sales a whopping $2.1 million dollars. But something was wrong. What had been a $175,000 yearly net profit when IGR was a mitigation-only company had turned into an $81,000 loss. What happened?
Steve quickly became overwhelmed — with work and having to estimate and negotiate restoration losses. So, he found a short cut. The insurance adjusters Steve worked with always wrote their own estimates, and these guys seemed to know what they were doing, so why not use theirs? Not having to write estimates himself took a huge burden off Steve, allowing him to spend more time managing jobs.
Steve had no idea what his reconstruction profit margins should be. He had always thought that whatever was left after you subtracted labor and materials from the price of the job was pure profit. Steve was unaware of a small term called “overhead.”
Finally, Steve only had one carpenter working for him, so he subcontracted almost all reconstruction work. His thinking was, as long as the subcontractors’ invoices equaled what the insurance adjuster had estimated for each trade, he would still make a tidy 20 percent profit, commonly referred to as “10 & 10” or “O & P” (overhead and profit).
What happened to the overhead?
Let’s do the math and see where Steve went wrong. He started with $1.4 million in reconstruction sales. Primarily utilizing subcontractors to perform the work, Steve assumed his profit on reconstruction would be $280,000 because it is equal to 20 percent profit of $1.4 million. But, his theory was flawed. The overhead and profit were already included in the $1.4 million.
Here’s how we got to that profit number: Actual reconstruction sales equals $1,166,667 multiplied by 20 percent overhead and profit for a total of $233,333. This gives us our $1.4 million. This also results in profits that are almost $50,000 lower than Steve had anticipated.
But, wait, there’s more.
It takes money to pay Steve and to pay for his vehicle, computer, phone, rent, utilities, etc. That’s the overhead part that Steve missed. Cost Of Goods Sold (COGS) is all he accounted for. COGS, in its simplest form, consists of direct labor, subcontract labor, and materials and supplies. An item Steve didn’t account for was overhead. And with the introduction of the reconstruction division at IGR, overhead had crept up to 35 percent of total reconstruction sales.
Doing the math on every reconstruction dollar that came into IGR, COGS accounted for 83 cents. (Remember our 10 & 10 only yielded 16.67 percent profit.) With IGR’s overhead amounting to 35 cents of every dollar, we are left with a net loss of approximately 18.33 percent or $256,620.
Add the net loss to the $175,000 profit earned on the mitigation side of the company and Mr. Boss is still left with a net loss for all operations of $81,620.
So, you tell me, is bigger always better? Or, in this case, would Mr. Boss have been better off concentrating on what he knew, mitigation?
You may think this is a wild exaggeration. But, while I have changed the names of the company and the people, this is a true story… or as close as I could make it without revealing the identity of the company — I used some “alternative facts.”
The lesson here is to focus on what you’re good at. If you choose to grow into a new area, either educate yourself thoroughly before beginning your new endeavor or hire people who can competently and skillfully fill that void for you. Don’t give away bottom-line profits for the lure of top-line sales.
Bill Prosch, CR, is a Business Development Adviser for Violand Management Associates (VMA), a highly-respected consulting company in the restoration and cleaning industries. Prosch is a leading expert in operations and a Certified Restorer. He has a deep understanding of entrepreneurial challenges having owned and operated a successful restoration company for more than 30 years. Through Violand, he works with companies to develop their people and their profits. To reach him, visit violand.com or call (800)360-3513.