The endgame of every business is profit. Profitability is measured at 3 key junctures: topline revenue, gross profit, and net profit. But what exactly are the factors that play in calculating profitability?
The cost of goods sold (or COGS) is one of the most fundamental metrics for residential home service businesses. Understanding what it is and what should be included in it is essential for managing your financial success.
In this article, we’ll explore what the cost of goods sold is and demonstrate how it flows to your bottomline.
What Are the Cost of Good Sold (COGS)?
Cost of goods sold, or COGS, are the variable expenses associates to selling and delivering your goods and services. Anything that is a perminent and steady cost is a fixed cost, and would reside below the gross profit line.
Cost of goods sold include the cost of all the equipment, parts, and materials you consume when delivering your solution, including all the little bits and pieces like tape, screws, and other consumable products. These unit costs should be inclusive of freight and storage costs, as well as any applicable state taxes. This may also include permits where applicable.
Cost of goods sold include the labor burden to install the products you sell, including any subcontractors or services needed to get the job done right. This also includes your callbacks and warranty calls, windshield time, and parts couriers for missing items.
Cost of goods sold include your sales commissions, bonuses, SPIFFs, and the like. This cost is traditionally generated based on the selling price of your sale, meaning you need to have a different calculation in place to get the total value added into your costs appropriately.
Cost of goods sold also include your finance charges. This includes the percentage you pay for credit cards, and any financial institutions you work with that charge you a fee for their loans. This also includes any fees you may pay to Costco, Lowes, or Home Depot for lead generation solutions. Like commissions, this cost is generated based on the selling price of your sale, meaning you need to have a different calculation in place to get the total value added into your costs appropriately.
Tracking your COGS lets you know exactly what price you can offer without hurting profitability. One thing is certain, you can’t beat a P&L. If your overall gross profit is less than your fixed operation margins, you’re losing money. Getting your COGS right is essential to building a pricing model that will translate to the bottomline.
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How Much Do My COGS Cost?
Let’s look at each one of the major constituent parts of your cost of goods sold for the HVAC industry.
Materials and Equipment
Any materials and equipment you use on the job are included in the cost of delivering the thing you sold. From the small consumable supplies to the equipment you install, materials and equipment must all be accounted for.
To get a sense of howe much you consume in raw materials, take the total sum of all of your supplies and divide it by the total number of paid jobs completed in a year. This will give you an average cost that you can apply to all jobs. Don’t forget to adjust this amount at least annually.
While many companies track permits separately in COGS, this section is as good as any for accounting for the cost of permits necessary for a job to be approved.
Also known as labor burden, this is the total cost of labor paid to install your products. This expense should include all install hours, time for parts couriers (for missing items) plus windshield time, apprentices, and training time. This category includes any subcontractors involved in the delivery. You can also include any services needed (eg. cranes or air monitoring) to get the job done.
Because installation is associated to the expense of sales, it is essential to factor in all installation costs, not just those assocaiatede to a job. In total, your intall departments total burden should represent no more than 9% of new unit revenue. That means teaching technician labor burden for service and maintenance work should be tracked separately, but still in the Install Labor section of COGS.
This category also includes your callbacks and warranty claims. While these variables won’t directly relate back to the specific job on a P&L, or even in a given month or year, it is still an important factor to track correctly to ensure your warranty and callbacks don’t spiral out of control.
Whether you pay stricktly commissions, or a combination of wage plus bonuses, they must all be tracked in the COGS. Your employee benefits are a fixed cost, alowing them to live below the gross profit line, but your sales compensation must factor into the cost of selling the goods.
Total commissions/pay package should not exceed 10% of applicable revenue, so knowing what revenue you do pay commission on and what you don’t pay commission on will allow you to better track your true expense.
In most instances, salespeople are paid on performance on topline revenue they touch. When you factor in discounting and negotiations, you need to ensure you have a different calculation in place to get the total cost added into your expenses correctly. Adding 10% commission to your prices will not net in a 10 point decrease in gross profit. It will be less.
Almost 100% of residential home service companies miss including finance costs on cost of goods sold altogether. These are all variable and dependent expenses applied only whan a sale is made, making them a cost of goods sold.
Finance costs include the money you pay for credit cards, financial institutions, and Home Depot (lead gen contracts). They do NOT include your monthly banking fees and credit card subscription fees. These are the fees that you pay regardless if you make a sale or not.
If you’re looking to achieve a 50% to 60% gross profit margin, adding in this variable expense is essential for correct profit margin measurement.
Like commissions, this cost is generated based on the selling price of your sale. You need to employ a different calculationto get the total cost added into your costs appropriately.
Credit card fees should sit below 2.5% in relation to all applicable revenue, and finance fees should not exceed 10% when applied to total applicable revenue. Alternatively, if you are not over 7% in finance expenses in relation to applicable revenue, you are likely not using finance to your benefit as much as you could be.
By placing this expense in cost of goods sold, you can easily factor in a discount for cash purchases, if you’re so inclined.
Cost of Goods Sold (COGS) Example
Your selling to a 1500 sq. ft 2-story house, with 3 bedrooms. Upon inspection, you learn that they need the following:
- A 2-ton split system.
- Refrigerant line set.
- New ductwork connections.
Let’s assume it will take your team of 2 installers two hours of driving to and from the location for the project, and eight hours to install. You pay them $40/hour each. Taxes on equipment is 6%.
The total cost of goods in this project would be:
|Equipment||$3,710 (inc tax)|
The total cost of goods sold for the installation is $8,154. If the buyer were to sign the contract at $14,969, you would have a gross profit of 60.5%. This is assuming a 10% finance expense and 10% commission.
If you wanted to negotiate the price but still collect a 50 point margin, you could reduce your price to $11,975 still paying 10% commission and pay your financing fees of 10%.
Whatever pricing strategy you employ, be sure to run the proper calculations based on your two different aspects of the cost of goods sold to ensure you remain profitable.