Service Department: Operating Expense Problem? Or is it really Gross Profit?

In completing dozens of expense reviews in 2007 for our dealer/distributor clients, I came across this issue on almost every occasion. When interviewing key managers, more often than not both the service managers and the controller were in agreement that they had an Operating Expense issue in the service department. They also were in agreement that they had no idea how to solve the problem. What I discovered on most of the reviews was the issue was not in expense control but was really a service gross profit challenge. Before we get too far down the road let’s define what we mean when we say Operating Expenses and Gross Profit.

As most of our clients will tell you, CMC has developed a financial model for distribution companies through our research and development projects with manufacturers. From there we have refined the financial model over the years through our experiences with the CMC Best Practices Groups. The Service Department Financial Model is as follows:

• Service Labor Revenue is pretty self explanatory. It is the labor charged to customers, whether it is internal, external, contract, warranty, etc.
• Cost of Goods Sold in our model is the wages of the technicians only. In other words, their W2 wages at the end of the year. Included in this should be their pay for vacation, holidays, sick time, etc. as those are true wages.
• Personnel Expense includes the benefits of the technicians (health insurance, taxes, workers compensation, etc.) Do not include vacation, holiday, sick pay, or other wages that are included in COGS. Also in here should be all the wages and benefits of the service overhead staff (managers, dispatchers, warranty clerks, aftermarket sales reps, etc.).
• Operating Expense includes all the expenses that are not either people related or building related. The largest of these expenses include service vehicles, liability insurance, supplies, telephones, etc.
• Occupancy Expense includes all the costs associated with the building/facility of the dealership or branch. Things such as rent/lease, property taxes, property insurance, heat, light, power and other utilities are the major expense items.

Now that we have defined the big buckets on the financial statement, let’s get back to uncovering whether you have a service operating expense issue or a gross profit issue. The biggest challenge I come across in performing the reviews with dealers/distributors is in how they are accounting for Service Recovery Items. These items are what you are charging your customers for service vehicles, shop supplies, hazardous materials disposal, etc. Let’s look at the example below.

At first glance you would conclude that there is a major issue with Operating Expense due to the fact that is over 5% out of line with the CMC model. Other areas of the department such as Gross Profit is less than 1% off model. This is not very uncommon to see in many of our Best Practice Groups.

But when we dig further you discover that $50 of Service Labor Revenue is actually revenue associated with charges such as mileage, zone charge, EPA, shop supplies, etc. that are common in most distribution companies. The CMC model would place those items not in Revenue but as a contra expense account under Operating Expenses. Now let’s look at what that does to the financial statement.

The bottom line figure of $245 did not change but we are now much closer to identifying the bigger issue. Operating Expense went from being off 5.2% down to 1%. Occupancy Expense stayed relatively the same but Personnel Expense jumped up 1%. But the biggest jump occurred in Gross Profit. It went from being off model by 0.7% to being off 2.5%. We have a bigger revenue and productivity issue and less of an expense recovery issue.

This happens in other departments as well. Think about the same exercise when it comes to Parts Freight Expense & Recovery. If you put the Recovery under Parts Revenue and the cost under Parts Operating Expense, you think you are doing well in margin but it is inflated.

So if you are wrestling over what you think is a Service Operating Expense issue, make sure you are accounting for the recovery items correctly. Place them down as contra accounts and match them up with the actual expense.

See you soon.