A fundamental calculation to make before buying or leasing a piece of equipment is to not only determine whether it will pay for itself but also if it will produce a profit.
There is a terrible calculation that is often used by those selling the equipment to “help” the potential buyer make this decision, and it generally goes something like this:
Sales revenue generated by the use of the product minus the cost of production in labor dollars for that operation. That number is then divided into the monthly payment to determine the break-even number. An example might look something like this:
- Equipment cost = $24,000
- Monthly payment = $845
- Sales price of service performed= $100
- Labor cost = $35
The equipment salesperson would likely say, “Divide your monthly payment of $845 by $65 ($100-$35=$65) to arrive at your break-even number of 13.”
He might then continue, “If you do the job 13 times you break even and pay for the equipment, and on the 14th time you make a profit.” With few exceptions, this is profoundly untrue in almost every case.
What the salesman wrongly assumes is that all of the revenue aside from the direct labor cost is applied to the monthly payment as a result of the use of the equipment. But we know this is wrong. We have fixed expenses that must be paid irrespective of whether we have customers or not. We need to know how much revenue we must produce each hour we are open to meet our expenses including desired profit. Is there a quick way to approximate how much revenue a piece of equipment must generate to cover our obligations and make a profit? Yes, there is.
Note your gross revenue for the last calendar/fiscal year and your pre-tax net operating profit, both of which are on your P&L. In its simplest form, your pre-tax net operating profit is the amount you are left with after all of your expenses are paid at the end of the year before paying the tax needed to pay on your profit. If your business had a gross revenue of $500,000 last year and at the end of the year you had $50,000 remaining (before taxes), your business would have a pre-tax net operating profit of 10%. An industry goal is 20%, though most independent shops are below 10%.
When we buy a piece of equipment, we must generate additional revenue to pay for it or be compelled to take the money out of company savings. In our example, the shop owner has a monthly payment of $845. If their shop has a pre-tax net operating profit of 10%, (he keeps 10 cents out of every dollar) the equipment must generate an additional $101,400 per year/ $8,450 per month/$405.60 per day (based on 250 working days per year) just to break even in one year. To accomplish that, they have several choices: 1) divide that figure by their average R/O and figure out how much additional car count he needs to pay for the equipment, 2) determine how much is needed to increase the current ARO to cover the cost of the equipment based on historical average, 3) raise his labor rate to spread the cost over all of the shops total average monthly hours.
There’s an old expression in business: “Gross revenue pay the expenses, Net pays the owner.” This calculation teaches us that the more we increase our net operating profit as a percentage of sales, the more we get to keep as owners. Additionally, it provides a barometer that we may use to measure our success and judge how well our business model is performing. As a bonus, it also helps to show us the true cost of the “discount” that we gave someone. Remember that $3 bulb you gave your customer? Well, if you have a 10% NOP, you need to sell $30 to pay for it.
The calculation I mentioned at the beginning of this column works if all of your monthly fixed expenses have been paid at a point earlier in the month. So, if you’ve had a great month, and by the Wednesday of week three (of a four-week month) you’ve paid all of your fixed expenses, then and only then can you apportion more of the revenue earned by use of the equipment towards paying for that equipment.
It's something to think about.
