Follow the Three Point Profit Rule

Jan. 1, 2004
by Terry Nicholson Running a successful residential HVAC business is not unlike climbing a mountain. When professional climbers set out to scale the most

by Terry Nicholson

Running a successful residential HVAC business is not unlike climbing a mountain.

When professional climbers set out to scale the most challenging peaks, they rely on the three point rule to reach the top. This rock climbing fundamental involves your four climbing points: your hands and feet.

Rock climbers strive to never break the three point rule, which means always keeping three of their points in contact with the rock. If they reach for an inlet above, both feet and their other hand must be securely planted. These three points create a solid foundation for the climber. Those who obey the three point rule safely reach their goals. Those who ignore it are doomed to failure.

The HVAC Three Point Rule

Like rock climbers, you must establish a strong foundation for your business before you can move forward. Your foundation is formed by the three pillars of a successful residential HVAC business:

  • Replacement
  • Service
  • Maintenance.

When your three points of replacement, service, and maintenance are solid, you'll be in position to reach the peak and your goal: profits. Consider this your three point profit rule.

Check Your Stance

Climbers must continually check their stance to ensure they aren't violating the three point rule. Likewise, effectively managing your business also includes regularly checking your foundation.

The only one way to determine if your three points are solid is to break them out independent of each other on your financial statements. If all your financials are lumped into one statement, you have no effective way of checking your foundation. You won't know if your service department is destroying your profitability, or if your replacement labor is too high. Losing sight of your three points can create financial disaster.

The Three Point Solution

To protect your climb to profits, track your three points. Get a separate statement for each of these areas of your business every month. Each of the three major segments of your business is comprised of three numbers you must track on your quest to the top.

Replacement numbers to track:

  • Labor
  • Equipment cost
  • Revenue

Service numbers to track:

  • Labor
  • Parts cost
  • Revenue

Maintenance numbers to track:

  • Labor
  • Revenue
  • The number of leads your maintenance generates.

Separate financials are needed to track each number because the target numbers for each area are different, and each point of your foundation relies on different variables for success. For example, maintenance is heavy on labor, while replacement is high on equipment cost.

Here's an example of how this works. If your goal is to run your maintenance department with a labor percentage of 25%, you'd be excited if your overall statement showed 25%. However, 25% in labor in your replacement department would be disastrous. In residential replacement, your goal may be an equipment cost of 33%, but this would be terrible in your service department. You must know these numbers, and to know them, you must view them separately.

Still not convinced? Here's a quick test. You've lumped your financials into one statement. You see that your labor percentage is 16%. Was it a good month or a bad month?

On the surface, you don't know. If you did all service and maintenance, your labor percentage is great. However, if the majority of your work was replacements, you're probably not making any money with a labor percentage that high.

The Magic Number

The replacement, service, and maintenance facets of your business and the numbers that influence them are the amounts that affect the most magic number of them all -- gross margin. Your labor, your costs for equipment, and your costs for parts all affect your direct costs, and that determines the level of your gross margin.

Gross margin is the magic number you should be watching, because it quickly gives you a glimpse of the financial health of your company. Simply put, gross margin is what you have left after you've paid the costs directly associated with a job.

Let's take a look at an example. You run a service call that generate $200. From that $200, though, you have to pay the costs of running that call in the first place. The cost of your parts was $24, and the labor to perform the work was $52. That means your direct costs for that call were $76, and when those costs are subtracted from the original $200, you are left with $124. That remaining $124 is your gross margin.

Now what? Well, if you divide your $124 gross margin by the original $200 in revenue, you'll find that you're operating with a gross margin of 62%. In other words, 62% of the revenue you bring in will be left after you've paid for the direct costs associated with it (namely, parts and labor).

Your labor and your equipment or parts costs are the two largest determining factors on your gross margin. The lower you can get your labor percentage and the lower you can buy your equipment, the higher your gross margin will go. When your gross margin goes up, your profits should go up, too.

Reaching Your Goals

What are the goals you should be striving to meet? Just like all of the other numbers you need to know to effectively manage your business, your gross margin goal will be different for each facet of your business.

For instance, in residential replacement, you should strive to hit a gross margin mark of 48%. When you install a new system into a client's home, you should have 48% of the original revenue left over after you pay your direct costs for that job. As your team becomes more efficient, your labor percentage will drop and you'll be able to buy your equipment at a greater discount. This will increase your gross margin.

When you look at the other facets of your business, the gross margin changes. Your service and maintenance should both be based on a gross margin of around 65%. Your gross margin in these disciplines should be higher than your gross margin for replacement for various reasons. For example, you don't have to worry about the high cost of equipment associated with replacement, so this should leave you with more revenue left over at the end.

The Path to Double-digit Profits

If you're striving to hit double-digit profitability in your HVAC company, this is where you start. Make sure your target numbers are close to these examples. Naturally, there are contractors in the industry today who blow these figures out of the water. These are the contractors who make tremendous profits every year. To be in that league, you must boost your gross margin to these levels and beyond.

Just improving your labor percentage or the price you pay for equipment will affect your gross margin and, thus, your profits. Remember your three point rule, and you'll be on your way to attaining peak profits.

Terry Nicholson is president of AirTime 500(TM), an organization dedicated to providing HVAC contractors with a competitive edge through proprietary tools, management expertise, marketing systems, training, and buying clout. For more information on AirTime 500, call 800/505-8885 or e-mail [email protected].