Pat F, Guest AuthorFeb 26, 2018 @ 10:41PM
Running a service business hopefully gives you some freedom and an opportunity to do what you really enjoy. But running a service business is hard. Running a profitable service business is even harder. Marketing to customers, hiring qualified staff, maintaining equipment, negotiating costs, billing, insurance, scheduling...these are the realities of your everyday existence, and they require a lot of work. That said, if this was all easy, everyone would be doing it, so if you're currently running a services business or thinking about starting one, kudos to you for having the courage to go out on your own. But going out on your own is one thing; making a nice living doing it is the real goal.
To know how successful you can be, you need to have a way to really see the health of your business and predict profitability. Doing so will help you plan better and position your company to grow, increase revenue, and earn the kind of living that makes all the effort worthwhile.
You know as well as anyone that this isn't a charity; you do all this work because you want to get paid. But with so many variables to keep track of, it can be hard to focus on the actual bottom line and make the necessary adjustments about where to where to invest, how to manage effectively, and how to allocate your time. There is a hugely helpful tool called a break-even analysis that can help you understand your business and begin making better decisions that will have a positive impact on your bottom line.
At its simplest, the break-even analysis boils down to this: how much do I need to sell in order to break even with the labor, materials, services, and other costs I have? This is especially important in the services field where you have different types of employees you have to pay, insurance that is unique to the work you do, and materials you have to regularly use on jobs. All your costs fit into one of two categories, and it's important to understand these because it's how you define all the money that you spend and invest to keep the business afloat. They are:
Fixed costs: These include costs that aren't dependent upon the amount of work you do or don't do. The rent for your building stays the same whether you have 10 customers or 100. Your business insurance, vehicle payments, and equipment costs are all examples of fixed costs.
Variable costs: Some costs scale up or down based on job volume; those are variable costs. Labor will be the biggest one of these, especially when you are paying employees hourly or by the job. You may also need to bring on additional people for seasonal work. Supplies are also heavily dependent on both the amount of work you're doing as well as market prices. Costs for materials can usually work in your favor when you buy in high volume, but can also work against you when you have to make one-off purchases when business is slow or when you can't predict the potential for more work.
To truly understand the financial state of your business now, and the possibilities for profit in the future, you have to be clear about all your costs and understand which category they fall into. Then you have to be thoughtful in conducting a break-even analysis to get perspective on where you're making and losing revenue, and how to make adjustments to get on course to profitability.
It's important to recognize why this analysis is important. Too many business owners operate on a day-to-day plan, which gives them no insight into the future and reduces their ability to control growth. These owners may be happy if bills are getting paid, but then are shocked when they have no reserve funds for when the business hits a bump or a slow season. If you put some effort into thinking through your business, you'll see that you can plan ahead, both to stave off any downturn in business, but also so that you can grow the business and increase profitability. The idea is that, with a little effort, you'd be surprised how much you can learn, and then if you're willing to make the necessary changes, you'll get better margins. That will ultimately give you more money to invest back into the business, as well as more money in your own pocket.
Most of the analysis starts with just being smart about your overhead costs in relation to the number of jobs you will need to carry out to break even. You should start by identifying all your fixed costs, and then break down how much each job will cost you in terms of labor, materials, and other things. Then factor in what you're charging (and make sure it's in line with market rates, which you can learn by doing some basic competitive reconnaissance) and determine if you're making a profit.
Now you have a sense for what you are making or losing. From that, you can make smart decisions about additional costs that come up. Can you afford to pressure wash all your equipment or purchase a new truckmount? Knowing where you stand financially will give you a far greater sense of what's available to spend. Keep in mind, however, that some of these expenditures will be a necessity. If you need a new transmission on one of your trucks, well, the money you spend to fix it will be less than the amount of money you'll potentially lose out on without the truck. So think in terms of "must haves" and "nice to haves." Even costs like a company picnic or holiday party can be adjusted based on the funds you have available to you or that you can reasonably predict through this analysis. Otherwise, at the end of the year, you could be stuck looking at a negative balance sheet and wishing you had curtailed expenses earlier in the year.
Understanding your business through the lens of its financial strength can help you also set business goals and revenue targets. Doing that can get you and your employees focused on generating new business rather than just waiting for the phone to ring. Proper analysis can tell you the number of jobs and amount you need to bill in order to break-even, and even how much work you need to do to create incremental revenue. Having targets and making them transparent to your employees provides everyone with a very understandable set of goals, and it helps them see how they contribute to the company's success.
Planning ahead through predicting profitability also helps you determine how much you can take on in fixed costs, as well as how many variable costs you can tolerate and still remain profitable. Insight into your financial health might help you make a decision to fix existing equipment rather than taking on more debt to purchase new items. As a business owner, you know how frequently you face decisions like this, and how frustrating they can be if you're making them without the proper knowledge of facts.
You also can be smarter about how you price your goods and services if you know how much you have to make for the year. While it may seem like a good idea to just undercut your competitors, if you do that and lose money, you won’t have gained much of a competitive advantage. Then again, if you can reduce the prices you charge in some areas with the knowledge that you can still turn a profit, you can be strategic about how you price, when to offer special discounts, and how much negotiating room you have when working with customers. That gives you greater flexibility and will help customers see you as a flexible partner.
Not all businesses are alike, so keep in mind that you have to know your own business really well in order to benefit from the actual analysis. That said, services businesses usually function according to one of two ways of looking at how they bill, and how they put their resources to work for their billable projects.
The following formulas can give you the data you need to get as close to spot-on as you possibly can in terms of predicting your profits for each of these three different types of service business types. Let's break this down:
Example 1: Unit = Clients
In this type of business, you are billing your clients almost completely for services. Goods and materials aren't part of your business and therefore most likely won't be part of your calculations.
For this business, let's say your fixed costs are $260,000 for the year. This includes staff, office space rent, utilities, insurance, and other costs. In this case, salaries are a fixed cost because they are paid irrespective of the number of clients or hours billed.
Sales price per unit
We estimate that the average amount of time needed per client to satisfactorily deliver services is about 100 hours per year. Based on market rates, you know you will charge $125/hour, which means for each client you'll earn, on average, $12,500 per year (and you thought you were done with word problems in high school).
Variable cost per unit
As we know, there are variable costs that will eat away at profits. We don't know which clients will cost more and which ones will have very few variable costs, but based on previous years' variable costs, we estimate that additional staffing, marketing materials, fuel, and other costs will run us about $2,100 per client, per year.
Based on all this, we can use this formula:
Unit = Client
FC = Total Fixed costs = 260,000
SP = Selling price per client = 12,500
VC = Variable cost per client = 2,100
Service business breakeven clients = FC / (SP - VC)
Service business breakeven clients = 260,000 / (12,500 – 2,100) = 25
We will need 25 customers in order to break even.
Let's look at what our balance sheet would look like:
Example 2: Unit = Hours
This is a business that charges by the hour, and we want to see how many hours need to be billed, and at what rate, in order to break even.
Fixed costs of the business are $85,000. This includes things like office rent, telephone, insurance, utilities, and some staff (office staff, for example). In this example, the labor costs for those employees working in the field is variable, based on the number of hours worked.
Selling price per unit
The per-hour cost for all services is $125.
Variable cost per unit
The actual labor cost to the business (salary and benefits) is $50 per hour. Since labor is increased or decreased based on customer need, it is considered a variable cost.
The business also estimates that any additional time spent with a customer beyond normal job scope amounts to an additional $7 per hour.
Here's our formula:
Unit = Hour
FC = Total Fixed costs = 85,000
SP = Selling price per hour = 125
VC = Variable cost per hour = 57
Service business breakeven hour = FC / (SP - VC)
Service business breakeven hours = 85,000 / (125 – 57) = 1,250
This business will need 1,250 billable hours in a year in order to break even.
A basic income statement for this business would look like this:
At this point, you should be able to put one of these two formulas to work, depending on your type of business. However, it should be used as a gauge and not as gospel. There are still variables and unforeseen issues that will creep into your business that you will miss if you only rely on your new break-even analysis. In other words, use this to help you predict and plan for your business operations, but don't become a slave to it. Keep your eyes open for all types of things that factor into everyday business scenarios.
Bear in mind that, most importantly, the analysis can't tell you how much demand you're going to have. If your business is pumping water out of flooded basements, and this happens to be a severe drought with no rain in sight for months, there's no analysis that will tell you business is going to be slow.
You also have to make sure you are using reliable data points, structure your units and prices correctly and are thorough in identifying and accounting for both variable and fixed costs. Be brutally honest with yourself in terms of how to evaluate the various parts of your business. Also be aware that you have to sometimes do things to beat the competition, and that can require costs you don't expect. So, again, use the break-even analysis as a signal, but don't think that it totally defines every aspect of your business.
A tech company CEO once said, "Most of the world will make decisions by either guessing or using their gut. They will be either lucky or wrong." With all the data available to us today, there's no reason to leave the future of your business to chance. Use the information you have to gain perspective on where your business is now and where you want to go. You know your business, so you know how you can adapt and change in order to get to your destination, but you have to know what that destination is. Know your costs, know your abilities, and make a smart plan for not just breaking even, but for being wildly profitable.