The goal and responsibility of every kitchen and bath firm is to be profitable over the long run so the business can invest in capital improvements and provide a return to the owners. If a business is not profitable, it will eventually fail, resulting in the loss of jobs and security for "stake-holders."
In order to insure such long-term profitability, a company's management must understand how costs, expenses and pricing come together – and how they interact to determine profit or loss. In this month's column, we'll examine these key components of a business and their relationship.
Most of us who've been in business for a period of time have evolved a strategy for our company. In the kitchen/bath design and remodeling business, the range of strategies begins with a "product-only" operation, where we focus on selling product to do-it-yourselfers or contractors. Or, we may add services to the products and become a full-service "design/build" remodeling contractor. There are obviously many opportunities to position your business somewhere in between these two extremes, as well.
However, as you add services to your repertoire, you'll also be adding overhead costs to your business. As this overhead portion expands, it's necessary to increase the portion of your revenue that's available after covering the direct cost of your sales.
MARK-UP & MARGIN
When product is sold, the first element to identify is the direct cost of the product. Stated another way: If we sell one more item of a particular product, what is the cost of acquiring that product?
In most instances, this will consist of the price we pay our supplier, plus the cost of having the product shipped to us. The difference between this cost and the price we charge our customer for the product is our gross profit, or gross margin. If our landed cost of a product is $100 and we sell it for $150, there is a $50 gross margin.
Let's pause here to make sure that we clarify the difference between mark-up and margin. This always seems to cause a great deal of confusion, and can produce disastrous results if it's misunderstood.
We can look at the example I just cited to help clarify the difference between the two:
Mark-up, on the other hand, is an expression of the relationship of sell price to the cost we've paid for a product. In this case, we would use a mark-up of 50% on our $100 cost to determine a sell price of $150. The danger comes if someone setting pricing knows that the company's guideline is to maintain a 33% gross profit and then marks up cost by 33% instead of 50%.
There are two major forces that influence how we arrive at the mark-up that we'll apply to our costs. The first is the amount of overhead that we must cover; the second is the impact of competition (the age-old law of "supply and demand" from Economics 101).
Determining what it takes to cover our overhead is a fairly straightforward calculation, as is illustrated by the following example:
(Rent, Utilities, etc.)
The other factor that now comes into play is the law of supply and demand, which will influence what sort of margins we might be able to achieve based on prevailing market conditions.
A gross margin percentage of approximately 40% is relatively common in the full-service remodeling business, including the kitchen/bath niche. We can determine what level of sales revenue we'll need to just break even (the point at which our gross profit just covers our overhead costs) by dividing the overhead costs above by 0.40. In the example supplied, this calculation results in a break-even point of $1,312,500.
The actual calculation can be refined to take into account that commission costs will likely rise with sales volume, since commissions are usually based on sales. Similiarly, other administrative and overhead costs will eventually rise as sales volume increases.
Another point to consider about margins and sales prices is the impact of cutting our margin to "sell that big job," a common temptation to all salespeople. If we cut our price by 10%, reducing our gross margin to 30%, we now must increase total sales required in the example above to $1,750,000 to generate the same $525,000 in gross profit.
LESSONS TO LEARN
One consideration that does not lend itself to a calculation is just how large an organization you want your company to become. A greater sales volume will normally generate a greater gross profit, but it will also lead to more employees, more equipment and a separation of duties and responsibilities. So, in developing your sales and pricing strategy, you need to consider how large and complex an organization you want to have.
Understanding the relationship between mark-up, margin, overhead and break-even will allow you to manage your selling strategy in order to maximize profit. Too often, the focus within a business is on the raw sales volume the business is generating rather than on the level of profitability the sales produce.
It's important that we consider the fact that when a dealer sells a custom-designed kitchen or bath remodeling project, it's virtually impossible for the customer to really make an apples-to-apples comparison of our pricing. It's also highly unlikely that a project will be lost over price to a competitor or even to the customer's budget. The fact is, we can design to a customer's budget while still maintaining our desired margin no matter the price point of the job.
Finally, we cannot ignore the necessity of controlling overhead costs. While we may have a good deal of leeway if holding prices, containing our costs will increase our bottom line and allow us to increase margin without having to raise prices. Similarly, we should not ignore the fact that there are highly skilled competitors out there who work diligently at controlling their cost of doing business.
Make sure that everyone in your company understands the relationships between pricing and cost. In most of our businesses, nearly everyone will be involved at some level in setting the pricing on contracts, products or change orders. You don't want them using your company's target margin percentage as the mark-up when they price these jobs.
To read past columns on Business Management by Bruce Kelleran, and send us your comments about this article and others, visit Kitchen & Bath Design News' Web site: www.kitchenbathdesign.com.