5 Money Mistakes to Avoid in Service Business
Even though there will almost surely be a healthy demand for HVAC service businesses, any service business is still at risk of going under. Most of the trouble comes down to money mismanagement or misunderstanding.
The good news is that the risks are avoidable with proper education and care. We aren’t accountants or lawyers, but we have learned a few financial tips over the years. Here are some common financial mistakes for service business owners to avoid.
Mistake #1: Not treating owner pay as an expense
Many business owners make the mistake of not separating their pay from the net profit. We recommend treating the owner’s salary as an expense, not something that can be taken from the profit after all the other cost calculations are said and done.
You’re free to determine the amount of money you want to take as a working owner. It can be as little or as much as you’d like, but you’re going to want to treat it like any other employee salary. As an owner, you probably won’t want to take out too much money for your salary because you’ll want to have a healthy net profit to fall back on. It’s better to have a financial buffer than to go into debt.
It’s good to separate your pay from the profits so you can use the net profit to grow your business and pay off business-related debt, not put food on your table.
Mistake #2: Not separating the cost of goods sold from overhead
When most people think of expenses in the service industry, they think of parts, labor, and tools. These costs are all directly related to service jobs, so they are factored into the cost of goods sold (COGS). These will probably make up around 60% of your company’s expenses over a given period, leaving you with a gross profit margin of about 40%.
A 40% profit margin sounds great, right? It sounds great, but we haven’t finished determining costs yet. The building insurance and staples you purchased for the office staff don’t factor into your cost of goods sold, but they still cost money. Those fall under overhead costs. You can expect those to take up around 30% of your business’s expenses for many service businesses. Your net profit would really be around 10%.
To keep a realistic image of your business profit, keep track of your overhead expenses and subtract them from your gross profit. (And remember that the owner’s salary comes from either the cost of goods sold or overhead costs, not the 10% net profit!)
Depending on the segment of business you are in and your mix of service and install your COGS will need to be 70% – 50% in order to make a solid and sustainable profit and weather the storms of business. Keep those separate from overhead in your books and your mental math so you don’t sell yourself short.
Mistake #3: Not distinguishing billable and non-billable hours
Your employees bring in your company’s revenue when they perform service jobs. However, they are also a significant source of your expenses. To determine the total cost of labor, you’re going to have to make some distinctions between billable and non-billable hours.
Billable labor is labor that directly brings in money. If a technician spends two hours on a job site fixing a customer’s heat pump, those two hours are billable because the customer pays for the service. However, a lot of your employee labor doesn’t fall under that category. Your employees don’t actively bring in money when they drive to and from job sites, stand by, or clean vans. Those tasks fall under non-billable hours, and your employees still need to be paid for them.
To get an accurate picture of your employees’ labor costs per billable hour, you’ll want to calculate your fully loaded labor costs. To do this, you can add up your employees’ total labor and payroll costs (including benefits and vacation time) over a set time period. You’ll then divide those by the total billable hours over that same period.
It gets trickier to determine labor costs if you don’t keep track of billable hours. If you keep track of billable hours and calculate your fully loaded labor costs, you will have a clearer idea of how to set your service prices to make up for those costs in your pricing and efficiency initiatives. Many companies that struggle do so because they fail to look at non-billable labor expenses and their causes.
Mistake #4: Improperly calculating markups
This is the big one. Unfortunately, it’s easy to go wrong here. Many business owners calculate a single job’s cost of goods sold by adding parts and labor. They’ll want to set a price that makes up for overhead expenses (30% for example) and leaves room for net profit (10%), so they’ll decide to apply a 40% markup. Intuitively, they multiply the cost of goods sold by 140% (1.40).
However, they won’t get a 40% profit by multiplying the cost of goods sold by 1.40. When they multiply the cost of goods sold by 1.40, they only add 40% of the cost of goods sold. They don’t figure out 40% of the entire job cost. The markup won’t even add up to 30% of the total amount collected, meaning that those business owners lose money despite the marking up 40% if they NEED to make 30% to break even.
Instead of multiplying by a markup, you can calculate a gross margin. You can successfully determine a 40% gross margin by dividing the cost of goods sold by 60% (0.6). When you divide the cost of goods sold by a percentage, you turn the cost of goods sold into that percentage of the total price. The leftover portion of the total price equals your 40% gross margin, which accounts for the overhead expenses and desired net profit.
Mistake #5: Being afraid to raise prices
It’s not easy to start a business without any previous financial data. When you first get into the service industry, your prices will likely come down to guesswork because you don’t know what your employee efficiency and overhead costs will look like.
The key to reaching your net profit goals is to adjust your prices to hit those targets. In many cases, business owners set their prices too low to make a desirable profit. It makes sense for them to raise prices once they know what their expenses are. However, they risk losing customers when they raise prices.
Losing customers is a valid fear. You can’t make any money without a solid customer base to support your business. However, the company will continue to bleed money if you don’t raise your prices and keep missing targets. Raising prices is a risk worth taking because many customers will understand and be flexible with pricing. Will you lose some customers? Almost certainly. Still, it will be impossible to build your business if you don’t take the risk of increasing your prices.
Running your own service business can be difficult if you don’t know how to manage your finances. Still, it can be a rewarding experience once you become aware of the common financial blunders and learn how to avoid them.