A Business Broker’s Tip to Improving Your Business Value – Determine Your Most Profitable Customers and Fire the Rest
Every contracting business and engineering firm has profitable and unprofitable customers. If you have not analyzed this, you should. In most cases owners are shocked when they perform this analysis. Take each customer (or product type or market group) and deduct the cost of goods sold to them. Fairly allocate overhead costs either by a simple blanket allocation of all overhead or by breaking out different overhead costs as they apply to different customers.
New Construction Blues
Take a look at this small mechanical contractor’s books. Simplified, they look like this:
Sales Revenue of $5,000,000 broken down as:
New construction $2,000,000
Residential service $500,000
Commercial service $2,500,000
Cost of Goods Sold $2,675,000 broken down as:
New construction $1,500,000
Residential service $175,000
Commercial service $1,000,000
Overhead totaled $2,000,000, broken up as:
Indirect labor (including owner’s salary) $750,000
Other overhead $1,250,000
Total profit $325,000
The simplest analysis to determine profitability is:
Customer Profitability Chart
Sales – COGS – Allocated Overhead = Profit
New Construction $2,000,000 1,500,000 $800,000 -$300,000
Residential Service $500,000 175,000 200,000 125,000
Commercial Service $2,500,000 1,000,000 $1,000,000 500,000
The overhead was allocated based on the percentage of sales of the customer type to total sales.
The next level of analysis might be to allocate indirect labor by the amount of time spent on each customer type. Track or, if you must, estimate payroll allocation to the hours spent direct marketing, supervising, meeting, getting paid etc. With new construction the profitability might decrease more.
As you can clearly see, this business is performing new construction services at a loss. Unless there is a really strong business reason, this business owner should either raise prices for new construction or focus on selling more residential and commercial service. Sales for the sake of sales is ego, (expensive ego) not a valid business reason.
You can make the argument that $100,000 of overhead is paid from new construction projects but that can be equaled with additional sales of under $200,000 of commercial services. Transition to the higher paying customers. The most profitable companies consistently perform this type of analysis and focus on their most profitable customers. Over time this is how exceptional profits are generated.
Greg’s Tip: Improving sustainable cash flow and profitability is the most effective way to increase the value of your business. This is by far the most important factor in determining business value. Sell when profits will be improving right through settlement.
Harvest Business Advisors
Business Brokers, Business Valuations, Business Transactions