In part one of this two-part series, we talked about creating useful categories and what “other” meant when it showed up on your profit/loss (P/L) statement. We also discussed how to develop a budget. Today, let’s look at a few more items concerning your accounting system that might be helpful.
Break material costs out by department
Having worked with landscapers one-on-one for over 30 years, I can honestly tell you fewer than 5 percent break their cost of materials/equipment out by department.
That may not seem like a big deal, but it is. When it comes to setting profitable hourly rates by department, knowing what material and equipment costs are is critical. Why? The reason is that materials/equipment are marked up before they are sold to the customer.
The marked-up amount provides gross profit, which is a key element in setting profitable hourly rates. The more markup you have, the more overhead cost can be absorbed in order to lower your hourly rate.
Budget your salary
If the cost of rent, insurance or gasoline were left out of your pricing equation, the end result would be an hourly rate that doesn’t cover all your costs of doing business and therefore does not generate a real net profit. That principle seems pretty straightforward and most thinking owners would never leave out actual costs that are that significant. However, it happens every day.
Owner after owner fails to input his/her salary as an expense into the P/L statement, with the reason being, “I will live off of the profit the company makes.” That sounds smart and even a bit humble, but it is not. If rent isn’t in your hourly rate, the rate charged will not cover your rent. If your salary isn’t in the cost of doing business, it won’t be in your hourly rate, either, and you won’t get paid.
Realize what your accounting system is not telling you
What your accounting system is telling you is very important. However, what it is not telling you is just as important, if not more important. There are two major expenditures that will never show up in your accounting system that are very real costs of doing business and have the potential to put the company out of business: depreciation versus equipment replacement costs and how loan payments are handled.
Depreciation vs. equipment replacement costs
Depreciation is an accounting term. Uncle Sam allows the owner to write off a percentage of the expenses each year. However, depreciation deals with the past cost of the equipment. Equipment replacement costs estimate the future costs of replacing equipment and then builds that future cost into today’s pricing so that replacement equipment can be paid for with cash. Equipment replacement costs will always be 20-50 percent higher than depreciation.
How loan payments are handled
Let’s assume a $500/month loan payment is made up of $100 interest and $400 principle. Uncle Sam only allows the $100 interest to show up as an expense in your P/L statement. However, the full $500 flowed out of your company and needs to be considered when setting proper hourly rates.
I once had a client whose business experienced the very phenomenon we are talking about above. His last twelve-month P/L statement showed a net profit of $109,000, which they had to pay taxes on. However, when we subtracted out the principle portion of his loan payments and the difference in depreciation and equipment replacement costs, his “real” net profit was really a loss of $81,000.
These are huge costs of doing business that literally will never show up in a standard accounting P/L statement, but they are critical to your company from a cash flow standpoint. Be sure you also include these two costs of doing business in your process of setting profitable hourly rates.
Review your P/L statement with your accountant each month
There are accountants and then there are accountants that understand business. If you are able to find an accountant that understands business (and they are a rare breed and hard to find), pay whatever they charge with joy. They will make you money, not cost you money. When you find that person, have a set time to meet with him/her each month to go over the previous month’s financials. An accountant that really understands business will question items every time he/she reviews your numbers and will offer practical suggestions on how to increase your overall profitability.
Remember, your accounting system should be helping you run your company more efficiently and profitability. Utilizing some of the above suggestions will help you better understand what is really going on within your company.
EDITOR’S NOTE: Tom Grandy is the founder of Grandy and Associates and has worked with contractors and green industry professionals for over 30 years.