The Importance of Budgeting

George “Butch” Welsch
Contributing Writer
Welsch Heating & Cooling

I realize that the training required to be an HVAC technician/installer is different from being an accountant, however, since many contractors started their careers working with the tools before becoming a contractor, some rudimentary knowledge of accounting is extremely important. This is brought home to me each year as for the last 25 years I have taught a class at our Sheet Metal Apprentice School on the Business Side of the Sheet Metal Business. The first question I ask of these 2nd year apprentices is how much net profit they feel their contractors make. The numbers invariably range from 5% to 50% with 15% being about the norm.

Given that all of the national studies show our contractors to have an average of around 2-3%, there is an obvious disconnect between what the men in the field believe and reality. This partially explains why the average life expectancy of an HVAC Contractor is 4 years. It takes about 3 – 4 years to find out that a lot of work and effort goes into making that 2 – 3% – if they are lucky.

Back to the accounting required to prepare a basic budget. We have developed a simple excel spreadsheet budget form which I will be happy to send you if you e-mail me at the address below. One of the most important things to remember in developing your budget numbers is to separate your expense items into direct costs and overhead items. In explanation this is simple but important. Anything that can be directly charged to a job should go in direct cost. This includes equipment, labor, materials, as well as such things as other direct cost items that are for a specific job. For example, permits; rental items such as cranes or manlifts. Again, anything that can be directly charged to a specific job should be in direct costs. Anything that can’t be charged directly to a job goes into overhead. These include many items, examples of which are building rent and utilities, office salaries, advertising, etc. etc. etc. Our example has all of these listed out.

As you review all of these Overhead items you will find that, for the most part, these overhead items are fixed costs. That means they will be there regardless of the amount of work you perform. A few are variable, such as gasoline, but in general you will have these overhead costs regardless of your amount of volume. Next comes the difficult task of determining the amount of volume you will need to have to cover that overhead with, hopefully, some profit left over. The important number that you must determine is your anticipated gross profit average. This depends upon a number of factors, with one of the most important being the market situation in your area. Even if you are brand new, you will rather quickly get a feel as to where your pricing must be in order to compete in your market. Then take a typical job, using that price point as the selling price and put together all of your direct costs. Subtracting those from your selling price gives you your gross profit (or gross margin).

For example if you have found that your average job can be sold for $ 5,000 and your direct costs are $ 3,500, then your gross profit would be $ 1,500 or 30%. If you have set your sights on a net profit of 5%, then that means your overhead costs can’t exceed 25%. Since you have already assembled your total overhead costs and determined your desired net profit to be 5%, you divide your overhead number by your combined overhead and desired net profit.(OH%+NP%). In our example we would divide our total overhead by [.25(OH) + .5(NP)]. If our predetermined overhead is, say, $ 500,000, then we would divide the $ 500,000 by (.25 +.05). This means our sales volume would need to be $ 500,000/.30 = $ 1,666,666. This would cover direct costs of 70% = $ 1,166,666 and leave $ $ 1,666,666 – $ 1,166,666 = $ 500,000 to cover 25% overhead ($ 1,666,666 x .25= $ 416,666) and leave us with $ 83,334 or 5% of sales ($1,666,666 x .05) net profit.

Obviously, a lot of things have to happen right for this scenario to be correct by the end of the year. We must attain $ 1,666,666 in sales at the 30% gross profit. If we lower our average gross margin by even 2%, that drops our net by 2% of $ 1,666,666 = $ 33,333 to now a net of only $ 50,000 instead of $83,334. This means we can’t drop our margin to obtain the sales. In addition, we cannot allow our direct costs to increase either, as a 2% increase in the job costs to 72%, reduces our net profit by an additional $ 33,333, down to only $ 16,667.

While your numbers will vary from these, the important thing is to take the time to determine, as closely as possible, what your overhead will be and then from there determine the sales price you must attain to achieve covering that overhead. Remember that even small reductions in the selling price that result in reduced gross profits, will greatly affect your end-of –the year bottom line.

Butch Welsch is the owner of Welsch Heating & Cooling, St.Louis. You can reach him at bwelsch@welsch-heatcool.com

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