CHAPTER Analysis and Action = To identify the major ways to affect profitability m To determine the best course of action to ™ To analyze the impact of various methods of increase production and/or reduce expenses, increasing sales and capacity taking into account the benefits and drawbacks m To analyze the impact of various methods _° the available choices of controlling variable costs To analyze the impact of various methods of controlling overall costs KEY TERMS bottom line break even point net loss average cost of salesAnalysisand Action m CHAPTER 16 Introduction By this point you should have a basic working knowledge of sales, gross profit, and net profit. In order to be able to effectively manage an automotive service operation an understanding of these concepts is essential. We have taken some time to explain the major factors that you, as a manager, can control and change in your effort to generate an acceptable profit. Now we can begin to use this information to understand how the decisions that you make can significantly alter the profit of your shop, your paycheck, and, ultimately, your job security asa service manager. Achieving a Net Profit Companies must eam a profit to survive. If they did not consistently do this they would quickly be unable to pay their bills and go out of business. As pre- sented earlier, net profit is the amount that is left after all expenses are deducted from the total amount of income as follows Income ~ Expenses = Net profit It is important to remember that the two ingredients of net profit (income and expense) are not always separate. As you make extra efforts to increase income, you may incur additional costs for those efforts (increased expenses). Likewise, as you try to curtail expenses you need to be careful that you do not trim services or quality that will result in fewer people choosing to purchase your service (reduced income) If you want to maintain or increase net profit there are only two factors that you can change, leaving you with the following three choices: 1, Increase income (sell more). 2. Decrease expenses (lower cost). 3. Do both. Increasing Income A great way to increase profitability that should always be strongly considered is through consistently increasing sales. In Chapters 25 through 28 we will discuss some of the tools that you can use to stimulate sales, such as advertis- ing, marketing, and merchandising, Stimulating sales is the best way to make sure that you are maximizing your use of the resources that you have at your disposal. However, if increasing sales is the sole focus of your business plan- ning, itis likely to produce very disappointing results. Without considering both of the ingredients of profitability, income and expense, you are likely to work harder, sell more, and file bankruptcy. Let us explore a bit litte further the contribution that increased sales can have to achieving and maintaining profitability. Increased sales contribute directly to the bottom line (net proit). Ths is especially tru if increased sales @) Bottom Line can be achieved while holding expenses constant. Figure 16-1 demonstrates this principle. In this example, the shop starts in January with total monthly expenses that are constant but exceed total income. ‘A-common business term meaning net gain or profitSECTION 4 Financial Measurement @ nettoss 'A-common term used to describe a negative net profit @ Break Even Point The point at which income exis expenses Break even Net prott B Indivect expenses 5 Direct expenses dan. Feb. Mar. Apr. May Jun. Jul Aug. Sep. Oct. Nov. Dee. Figure 16-1. Increasing sales with constant expenses ‘The shop is losing money (net loss). The shop increases sales 5 percent monthly while holding expenses constant. You can see how this increase in sales helps them to move from a monthly net loss to a monthly net profit. In this example you can clearly see that with constant expenses and steadily increasing sales the shop’s financial picture begins to change as the ‘eat progresses. They begin the year where the expenses exceed the sales and ‘hey are generating a monthly net loss (income < expenses). This is true for the first four months of the year. However, with the steady increases in sales the loss continues to diminish. In May, they reach the point where income equals expenses. This is called the break even point. Finally, in June they achieve their first net profit (income > expenses). Then, as the sales continue to increase, the monthly net profit grows. If it were always possible to hold all of the factors constant while changing only one, management would be a much simpler job. However, sales and income do not typically increase without any increased costs. For example, if technicians are paid flat rate, an increase in flat-rate hours (sales) also results, in an increase in technician pay (direct expense). Although the profit does increase, you can see in Figure 16-2 that it takes a little bit longer for the shop to move from a net loss to a net profit. Break even Net prof Net oss \y Sales Net proft Indirect expenses i Direct expenses Jan, Feb, Mar. Apr. May Jun. Jul. Aug. Sep. Ost, Nov. Dee. Figure 16-2 Increasing sales with increasing direct expensesAnalysisand Action m CHAPTER 16 A third possibility is that when you increase sales you are going to increase both direct expenses (technician pay) and indirect expenses. Here are two examples of how that might occur. If you aggressively focus on increased sales as the only means to increase profit you might consider advertising to a wider audience to bring people into your shop from far away. Unfortunately, in order to do that you will have to spend more money to advertise (increase expenses) to let those people outside of your local area know about your serv- ices and to give them a good reason to travel further to see you, and advertis- ing is not cheap. Your indirect costs will be increased. So, just as in the previous example where increased sales have increased direct expenses, in this situation both your direct and indirect expenses increase. The resulting profit chart will look something like Figure 16-3. Netioss Break even ~~ Net prott ES Net promt Sales’ | Indirect expenses |S Direct expenses vlan, Fob, Mar. Apr. May Jun. Jul, Aug. Sep. Oct. Nev. Dec. Figure 16-3 Increasing sales with increasing direct and indirect expenses Asyou can see in this example, sales have continued to increase at a constant rate. Direct expenses have continued to slowly increase in direct relationship to the increased sales. Now, when we add a small monthly increase in indirect expenses to account for a small increase in advertising, the profit picture has changed again. The break even point is not reached until November and the shop achieves a net profit for only one month, December, and it is small. If you are able to attract people from farther away to come to your service shop, you will reach a point where your shop is too busy to handle all of the work. Then what will you do? Will you stay open later? You would have to hire more technicians and more support personnel to staff your shop (increased expenses). For each small increase to expenses the break even point ‘moves further and further into the future. final example of the possible results of increasing sales would be when you teach the point where you have to consider moving or adding on to the facilities just to keep up with the increase in business. When this happens you will be increasing indirect expenses by a significant amount. You need to remember also that the expenses for the facility (building costs plus utilities) are overhead expenses and, by their very nature, the most difficult to control. Once you have built an addition you cannot easily make it go away. Therefore, the added indi- rect expenses will continue no matter what happens to your sales. This signifi- cant and constant increase in indirect expenses is represented in Figure 16-4. The example shown above demonstrates the effect of a 25 percent increase in overhead such as one that would occur with a building expansion. As youSECTION 4 Financial Measurement Netloss Break even NOT reached Sales ES Net loss & Indirect expenses Direct expenses ven. Feb. Mar. Apr. May Jun. Ju Aug. Sep. Oct, Nov. Dec. Figure 16-4 Increasing sales with a 25% increase in overhead, can see, even though all other factors remain the same, the increase in indirect costs is both significant and immediate. The impact of the change is that the break even point is pushed further off into the future and the shop does not achieve its break even point by the end of the year. Although it is a good way to increase profit, sales growth is not the only answer, Even the best marketer with the best product finds that there are lim- its on how much he can sell. Further, there are always external factors beyond your control that will cause your sales growth to level off or even decline. For example, if you are selling service in a small town and you have the best service available itis still very unlikely that you will sell more oil changes than. there are cars in the county this month. There is a limited market and, there- fore, a limit to the amount that you can sell. I hope you have noticed that there is a recurring theme in the four examples presented. It seems that every time you try to increase sales you have to do something that is going to cost you more money. These examples are typical and help to explain the reason why focusing on increased sales alone is nota long-term solution to making a profit. Consistent profitability is, achieved through a combination of increasing income and controlling costs. Let us talk more about how to control costs. THEORY INTO PRACTICE 16-1 CASE1 You decide Congratulations due to your marketing efforts your What do you do? shop business hes grown by 40 percent. Unfors a, Raise your prices? ‘nately, you are now experiencing a shortage of space 'b. Hire more technicians and start extended service eae tere ata to wait so long to get an appointment to have you moreariharcn Buy a bigger building and move into it? 4d. All of the above. Please explain the reason behind your choiceCASE Your business has been slowly decining over the past ‘wo years, You know that you still have a good reputa- tion in the local community, but things have been tough in your town due to them closing down two local manufacturing plants. You are faced with making some tough decisions to keep your shop profitable, Analysisand Action m CHAPTER 16 THEORY INTO PRACTICE 16-2 You decide What do you do? ‘a, Lower your labor rate? b. Advertise more outside of the local area? Hire lower cost technicians? d. Allof the above, Please explain the reason behind your choice. Controlling Expenses In the automotive service shop there are two main areas where expenses can be controlled. The expenses that are most clearly under the control of the service manager are the direct expenses. The main source of these expenses is techni- cian payroll expense. In Chapter 14 we discussed the different methods for paying technicians. It is suggested that you consider going back to review this, information if you are unclear about the differences between these pay plans. Since flat rate continues to be the most common pay plan for technicians, we need to take a look at how this method of pay affects gross profit. The chart in Figure 16-5 shows the relationship between technicians’ pay and the gross profit when the technicians are being paid solely on flat rate. Sales im Gross profit 1 Direct exponsos Jan, Feb, Mar, Apr. May Jun. Jul Aug. Sep, Oct. Nov. Dec. Figure 16-5 Relationship of flat-rate pay to gross profit ‘There is a ditect relationship between technician pay and gross profit in the flat-rate system. This means that if the sales increase, so do the direct expenses. If the direct expenses are too high, there is only one way to reduce them— reduce technician pay. This may sound simple but itis definitely not. Due to the consistently high demand for technicians and the need for qualified technicians,SECTION 4 Financial Measurement Average Cost of Sales ‘The average labor cost for all repairs performed in the shop. to do quality work, itis difficult to recruit and retain technicians. You certainly cannot expect to recruit and retain qualified technicians by underpaying them. You cannot afford the consequences of underpaying a highly skilled and experienced technician. Fortunately, not all work that comes into your shop requires a high level of skill and experience. The typical repair shop performs a wide range of maintenance and repair services which require lower levels of skill and experience. Therefore, it is possible to control the overall direct expenses by altering the ‘mix’ of technicians. That is, changing the combina- tion of A, B, C, and D technicians that you have in the shop changes your average technician pay and your direct expenses. Maintaining the proper bal- ance of technicians within the shop to meet the needs of the customers is the solution to controlling direct expenses. Although it would seem ideal to have a shop full of the top technicians in the world this would pose more of a problem than it would be a benefit. Top technicians demand top pay. However, asking a $26 per hour master certified technician performing $22.95 oil changes is a waste of talent. It is also a waste of money. It is likely to create employee dissatisfaction by making the techni- cian feel like he is wasting his skills doing menial tasks. The way to resolve this, problem is to hire personnel with the right skill levels to do the job. Here is a simple example of how choosing the right technician for the job can influence the cost of sales and gross profit. A very common service pro- vided by every service shop is an oil change. It is common to see these repairs advertised at the price of $22.95. If the shop intends to sell the oil change for that price and has a total cost for the oil and filter of $5.95, they are earning $16.00 per oil change in labor. All technicians are paid 0.3 hours to perform this service. Although the labor sale amount will be the same on every oil change that they do, the gross profit will change dramatically depending on which of their four levels of technicians performs the work. Figure 16-6 shows the gross profit and gross profit percentage generated by these four different technicians, who are all are capable of doing this very basic service. The only factor that changes is their hourly flat-rate pay rate. ATechnician| B Technician | C Technician | D Technician Tech Flate Rate $26.00 $20.00, $14.00 $8.00 Customer Labor Rate | $60.00 $60.00, $60.00 $60.00 Tabor for Oi Chg. 03 03 03 03, Labor Sale $18.00 $76.00, $18.00, $78.00 Cost of labor $7.80 $6.00 $4.20 $2.40 Gross Profit $10.20 $12.00 $13.80, $15.60 Gross Profit % 57 7 TT a7 Figure 16-6 Labor and gross profit for an oil change Based on this example, the shop can vary its gross profit from $7 percent up to 87 percent solely based on who does the oil change. Having the proper ‘mix of different skill levels of technicians is the key. This will allow supervi- sors to assign work to capable technicians without overpaying an expert to performing routine work. Achieving the proper average cost of sales in a shop so that you can maintain the proper gross profit percentages is essential to achieve profitabil- ity. You cannot afford to have costs so high that you constantly lose money.Analysisand Action m CHAPTER 16 Conversely, you have to spend enough money to retain technicians with the tight combination of skills and experience to fix cars right the first time. It is the delicate balance of these two factors, cost versus expertise, which makes staffing a repair shop such a difficult challenge. In Chapter 15 we discussed alternative production plans that can be con- sidered to deal with the problem of staffing costs, teams, and support groups. ‘They were created to try to reduce average cost of labor while not sacrificing overall quality of repairs. Taking into account the possibility that we might be able to use production plans as a tool to control cost, let’s revisit a scenario similar to the ones that we have just discussed to consider alternative methods to address the question of controlling average cost of sales. Average cost of sales is a very important measurement tool in trying to control costs. You can calculate average cost of sales by doing the following three simple steps: 1, Calculate total hours produced by each technician mut hourly rate. 2, Add the totals of all technicians together. 3. Divide the total by the number of technicians. ied by their ‘This will give you the actual average cost of sales for the entire shop during a specific period of time. This average will change as business goes up and down and as individual technician productivity varies. Therefore, it is an important ‘measurement to track on a regular basis so that you can monitor your current cost and gross profit. It would be easy to manage and control the cost of sales and gross profit if business was stable. Unfortunately, business never remains constant. As a manager you cannot assume that the type of work that you are getting in your shop will be exactly the same every day. Finally, the productivity of your tech- ians is dependent on a variety’ of factors including the type of work that they get, their level of motivation, their health, and so on. This makes the decision-making process for properly staffing your shop and maintaining the required profit margins quite a bit more complex. ‘Asa final exercise in this chapter, we will take another look at a situation simi- larto the ones that we have addressed in the previous exercises. However, this time ‘we are going to add in the fact that not all of your technicians produce exactly the same amount of work every week, a variable that is a reality in most shops. THEORY INTO PRACTICE 16-3 CASE1 You decide ‘Your goal is to staff your shop with four technicians Using Figure 16-6 as your guide and assuming that ‘and maintain an average cost of sales that allows you _@ll of the technicians produce exactly the same num- to earn a gross profit of 72 percent. You run a full. ber of flat-rate hours per week, how many combina~ service shop and need technicians that can do every- tions of technicians out of the four categories can thing from oil changes to electronic diagnosis. you arrive at that will give you a 72 percent gress profit? Which of these combinations would you choose if it was your shop? Why?SECTION 4 Financial Measurement Gj C ( X si THEORY INTO PRACTICE 16-4 CASE ‘You are managing a four-bay shop thatisa franchise of ‘one of the large tire companies. In addition to selling and installing tires your shop specializes in frontend ments, brake jobs, and preventative maintenance services. You de not do any heavy repairs or electronics diagnostics. You send those back to the dealers. You decide Using Figure 16-6 as your guide and assuring that all of ‘the technicians produce exactly the same number of flat- rate hours per week, what combination of four techni- «ans would you select to staff your shop? What would be your average cost of sales? Average gross profit per- centage? Why did you select this mix of technicians? * THEORY INTO PRACTICE 16-5 CASE1 You are tring to track the actual average cost of sales for your service department. You currently have four technicians working for you. Their information is as follows lisa Fred Technician Flat Rate $26.00 $20.00 $14.00 $8.00 ‘Omar Horace You decide Using this information, please calculate the average cost of labor if 2. Lisa, Fred, Omar, and Horace all produced 40 hours: last week. b. Lisa produced 50 hours, Fred produced 40 hours, (Omar produced 40 hours, and Horace produced 30 hours last week. Lisa produced 60 hours, Fred produced 40 hours, (Omar produced 36 hours, and Horace produced 24 hours last week. a OT DO ee CASE ‘Your goal isto staff your shop with six technicians and, ‘maintain an average cost of sales that allows you to ‘earn a gross profit of 72 percent. You run a full-service shop and need technicians that can do everything from oil changes to electronic diagnosis. You decide Using the chart as your guide and assuming that all of, ‘the technicians produce exactly the same number of fatrate hours per week, what combination of techni- ans from the four classifications would you choose to achieve an average gross profit of 72 percent or more using a traditionally organized shop? Please explain ‘why you chose this combination of technicians. ‘Technician B Technician’ (CTechnican Technician Technician Flat Rate $26.00 $20.00 $14.00 $8.00 Weekly Hours Produced 56 48 32 24 Customer Labor Rate $60.00 $60.00 $60.00 $60.00 Gross Profit $34.00 $40.00 $46.00 $52.00 Gross Profit % 57 67 7 87Analysisand Action m CHAPTER 16 (ag THEORY INTO PRACTICE 16-7 CASES You achieved your goal of a 72% gross profit in the last exercise. Your owner has just returned from a national conference and tells you that 72% isn't good enough. He wants you to explore alternative produc- tion plans. j— Reat Wor AppPLICATION It is important as a manager that you achieve a sense fof balance in your actions, Just because you are suc- cessful today it is usually a bad strategy to let things, run the way that they have. You should constantly analyze your performance and look for ways to con- sistently improve your operation and increase your profitability On the other hand, you cannot afford to make sweeping changes daily, Implementing change haphazardly without a great deal of thought and You decide ‘What would be your technician staffing choices if you ‘were using the team system production plan? What {ross profit percantage would you achieve using this choice? Which technicians would you choose if you ‘were using a support group? What gross profit per- centage would you achieve using this choice? consideration will create a great deal of unrest among your employees and is likely to cost you a great deal through employee dissatisfaction and a dramatic increase in employee turnover. You need to strike a balance and carefully keep ‘track of the data, You need to track it, analyze it, and then when you are sure that it is not just a short-term issue you will be prepared to cautiously and thought- fully take appropriate action. ( ss eS eC or) CASE Your goal remains to produce a gross profit of 72 percent or higher in a shop of six technicians. You decide Using the chart provided, how would the gross profit results change for the staffing choices that you made in the previous exercise where you selected your technicians for the three production types (traditional‘team/upport group) i you learned that ‘the four technicians consistently produced the num- ber of hours listed in this chart? ‘ATechnician B Technician (Technician D Technician Technician Flat Rate $26.00 $20.00 $14.00 $8.00 Customer Labor Rate $60.00 $60.00 $60.00 $60.00 Gross Profit $34.00 $40.00 $46.00 $52.00 Gross Profit % 7 or 7 87SECTION 4 Financial Measurement [summary In this chapter we have explored a variety of scenarios to help you deepen your understanding of the importance of sound financial management, Through the use of these examples we investigated the potential benefits and drawbacks ofa variety Of different actions that have an impact on your bottom line, We discussed how increasing income serves as a primary method for increasing net profit. We then discussed how increasing income is rarely done without any effect on casts. We looked at several common situations where increasing income isthe cause of increased costs. I PRACTICING THE PRINCIPLES 1. By reducing the average cost of sales the service man- ager can ‘increase labor hours. b. inctease gtoss profit. reduce the overhead. d,_ reduce overall sales. 2. Asservice manager can reduce cost of sales by ‘2. replacing his top technician with a lower paid one. b. hiring more entry level technicians ata lower rate . culting every current technician's pay. , all of the above, although | would not recommend it. 3. The term average cost of sales refers to ‘a. the total hours produced divided by the number of technicians. b. the normal mount of hours that John turns weekly every year. . the average pay rate of your technicians divided by forty dd. none of the above. 4. Ashop achieves the break even point when a. ittinally makes a net profit gross profit — all other expenses = 0. . income — expenses = 0. dd, more than one choice is correct 5. If you want to inctease your shop's gross profit you can a reduce your overhead expenses. b. increase cost of sales. \We then spent the remainder of the chapter looking at a variety of different ways that you can bring cost of sales under control and keep it under control. We applied some of the concepts that we learned in previous chapters to help us reduce fixed expenses and, thus, increase gross profit. We then worked through several exercises that demonstrated how changing the mix of technicians in the shop and alterna- tive production plans can help you to increase your gross profit percentage. c. increase fixed expenses d. increase labor sales. 6. Ifyou want to increase your shop's net profit you can ‘reduce your overhead expenses. b. increase cost of sales. increase fixed expenses. reduce labor sales, 7. If you want to increase your shop's gross profit percent ‘age you can {2 increase your total labor sales, b. increase cost of labor sles. ‘c. decrease your fixed expenses. d. decrease average cost of sales. In Questions 8-10 you have two technicians working for you. Your shop labor rate is $50 per flat-rate hour. Jeremy, who is paid $20 per flat-rate hour, tutns 60 hours this week and Alfred, who is paid $10 per flat rate per hour, produces only 30 hours. 8. What is your average cost of sales for the week? 9. Whatis your total gross profit for the week? 10. What is your goss profit percentage for the week?