Knowledge Base

Are Your Services Profitable?

By: Kenneth J. Wasmer

The Great Myth:
Everywhere you turn these days people are saying that you can no longer make money on moving boxes…service is where the money is. This may be one of the greatest myths in the channel. Not in the sense that you can not make money with services, but from the standpoint that few resellers are, in fact, making money on services.

When I first say this I generally receive universal head shaking. "No way," says a reseller, "my services produce a 50% gross profit, while I struggle to sell boxes for 10 points." Another reseller adds, "I have my departmental financials here to prove I'm making a considerable profit on services." The next reseller sums it up, "How can you say we don't make money on services when I sell my engineers at three times their salary?"

Herein lies the problem. It "appears" that resellers are making money in services. Based upon departmental financial statements almost all service departments show a profit, however, in looking at these same financials in more depth, this is seldom the case. The financials simply do not include all costs of running a service department.

Philosophically, the problem is fairly simple. Services must stand on their own. However, most resellers still allocate most costs to the hardware side of the business. The following is an actual departmental financial statement of an $8 million reseller:

Labor Revenue		$ 475,136
Parts Revenue		100,533
Costs of Sales		60,319
	Gross Profit	$ 515,350
Salaries		393,900
Travel		9,020
Office Supplies		1,897
Pager Expense		2,394
Telephone		2,366
Contract Labor		3,515
Training		7,575
Dues & Subs.		522
Misc. Expenses		2,198
	Net Income	$ 91,963

Based upon the departmental financials this reseller appears to be profitable. Overall the company made $119,901 on $7,398,022 in total revenue. Therefore, the owner concluded, services accounted for almost 77% of his total profit. Net income on services was almost 16%, while the hardware side produced net income of $27,938 on $6,822,353 in revenue, or just .4%. Clearly, services were far more profitable. Or, were they?

First, and most obvious, is the fact that this reseller has only accounted for controllable direct expenses of the service department. There are no uncontrollable costs included. For example, there is no rent or utilities. The following expenses should be allocated, to some extent, to the service department:

Rent and Utilities:

Allocate on the basis of space utilized, or based on the number of employees. This company had 21 employees, of which, 10 were engaged directly in the service department. Utilities should be allocated based upon number of employees.

Insurance:

Business insurance should be allocated in the same ratio as rent for general liability while insurance on assets should be allocated based on relative inventory.

Legal & Professional:

Try allocating based upon actual usage. In general issues some argument can be made for allocating based upon overall revenue or based upon the number of employees in each department.

Advertising:

Here is where most resellers allocate almost all of the costs to the hardware sales. If service is allocated any costs, it will generally be allocated based on revenue. A more appropriate allocation method might be on gross profit.

Accounting and Administrative Costs:

Think of it this way… what would the costs be to run a service only business? For example, the receptionist answers the phone, the purchaser buys the parts, the warehouse clerk receives the parts and handles returns, the accounting clerk invoices the customer, the A/R clerk collects the receivables, the controller prepares the financials, etc. These costs are usually borne by the hardware box moving operation. However, many times the administrative costs are greater for the service side of the business.

To illustrate, how many service and support phone calls are received, as opposed to calls for hardware sales? With A/R collections, how many times will the customer not pay the invoice because they have a problem with the product itself as opposed to the system is not set up properly or the service work is not completed? How much effort is spent in "purchasing" unique parts (one at a time) and handling receipts and returns, tracking bad parts and warranty reimbursements?

Selling Costs:

Selling costs represent one of the larger line item expenses outside of direct labor. Most companies pay their sales reps commissions for selling services, in fact, many companies pay a higher commission on services in order to incent the reps to sell more services.

When commissions are paid the question arises as to what is the gross profit. Some companies will pay based on an "arbitrary" 50% gross profit figure. Others will subtract the direct costs of labor (the hourly rate may be multiplied by a factor of say, 1.3, to account for taxes and benefits). The fallacy with each of these two scenarios is that they do not properly reflect the actual costs. Actual direct costs tend to put the gross profit on services at 30% or less for the average reseller.

In spite of this, companies will still pay commission on the higher gross profit rates. The reseller in question compensated reps at 20% commission and used 50% of revenue as the gross profit amount.

Fixed Asset Costs:

Another major cost that is seldom allocated to the service department is the fixed asset cost. Each employee will need a desk, a chair, a computer, a phone, etc. in addition to the departmental equipment. Also, the department needs a share of the overall company's equipment (ie: phone system and network server). Keep in mind that in addition to the actual direct fixed asset cost, the service department should be allocated a piece of the fixed asset cost of the general and administrative department as well as part of the sales department.

Management Expense:

The expense of the executive management of the company (president, CFO, COO, etc.) should also be allocated to the service department. Many resellers will allocate based on revenue. Again, the service department makes up over 45% of the employees (from an allocated standpoint the service department has over 60% of the employees) and produces almost 37% of the financial statement gross profit, yet has less than 10% of the total revenue. Allocating based upon gross profit or on employees is more realistic.

Interest Expense:

Interest is generally allocated to the hardware side, the logic being you only have interest with the floor planning and A/R lines associated with the hardware. The reason is that you have tangible collateral supporting the credit facilities. If you don't pay your creditor, they will repossess the inventory. It is difficult for the lender to repossess "service".

However, it does take capital to fund a services business. Most services are actually invoiced after the service is completed. Because the "labor" and "overhead" can not be financed as easily as hardware, the reseller sometimes has to fund more than 100% of the invoice (this happens if the service is invoiced at the end of the month and the customer takes more than 30 days to pay). The point here is that, contrary to popular belief, it does take cash to run a service company. How much cash and how much interest needs to be allocated needs to be evaluated based upon actual receivables and cash usage. Departmental cash flow projections should give good clues as to the cash needs.

SUMMARY

After analyzing the financials of the reseller above, the expenses were reallocated to determine "new" costs for the service department. Factoring these costs into our departmental financial statements, we get the following: Previous net income $91,963 Rent 19,000 Insurance 3,000 Legal & professional 4,800 Advertising 4,300 Utilities 3,600 Accounting & Admin 48,000 Selling Costs 42,857 Fixed assets cost 16,667 Management expense 41,250 Interest expense 7,500 Adjusted net income ($99,011)

After properly allocating expenses this reseller's "profitable" service department was actually losing money. This is more often the case than not. The problem is that services have always been viewed as an adjunct activity to the traditional box mover. Many times these services were given away as part of the margin on the box. Many other resellers see services simply as a way to increase margins, or to lock in a customer. So, today, as more resellers charge for these services they do see improvement in their financials, not so much from the profits from services, but from the fact that the loss has been lessened.

I do believe resellers can, and more importantly, must make money on services (because I have seen many resellers that do). The key is increasing the utilization rate of service employees while understanding the true costs of services and pricing them accordingly.

 

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