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Online Exclusive: Accounting basics for small contractors

Aug. 14, 2013
According to a 2012 University of Tennessee research report on business startups, the construction industry has one of the highest failure rates of all industries. After four years, only 47% of construction startups are still in business. After five years, the highest failure rate for startup businesses occurs in the plumbing, heating and air conditioning industry.

This is the first article in Michael Bohinc’s Accounting Basics online series. 

Michael Bohinc, CPA
According to a 2012 University of Tennessee research report on business startups, the construction industry has one of the highest failure rates of all industries. After four years, only 47% of construction startups are still in business. After five years, the highest failure rate for startup businesses occurs in the plumbing, heating and air conditioning industry.

The study states that business incompetence is the primary cause of their failure. Specifically, the owners either have no knowledge of pricing or use emotional pricing in their businesses. In addition, they don’t understand financing; have no experience in recordkeeping and lack planning skills.

What is emotional pricing? It’s the practice of basing your pricing on a feeling, mood or emotion rather than factual data and information. Does this sound familiar? “I can’t charge that much. The customer won’t pay that much for this. My competition only charges … for that service.”

The lack of financial skills is a primary reason why our industry’s average net profit margin is a dismal 3.5% (Industry Data & Analysis Report for the P-H-C Industry, Sageworks). This is the first in a series of articles that will address this issue and focus on accounting for the smaller contractor (five truck and smaller companies).

How does it all start?

Typically, it starts with a plumber or HVAC technician who is unhappy in their current employment. They have what world-renowned small business consultant and author Michael Gerber calls an “entrepreneurial seizure.” They make the fatal assumption that because they know how to do the technical work, they can own a company that does the technical work. In this case, it’s plumbing, heating and cooling work. This is simply not true.

How does being a great plumber make you a great businessperson? That’s like saying “Since I’m a talented florist, I would make a good attorney.” One has absolutely nothing to do with the other. This is exactly how many talented plumbers and HVAC technicians fail. Being a contractor in these professions requires as much, if not more, training in business skills as it did in becoming a licensed plumber, electrician or HVAC technician.

Why does the plumber or HVAC technician go into business for themselves? There are many reasons. They include:

·         Thinking they can do a better job than their current boss.

·         Wanting to be their own boss. Do things their own way.

·         Wanting to spend more time with their family.

·         Wanting job security.

·         Wanting to make more money working for themselves than someone else.

In my opinion, that last reason is the primary reason: to make more money and provide a better standard of living for their family than they could have working for someone else. The only way that you can make more money while spending more time with your family or pursuing your favorite hobby is to properly price your services.

Working for someone else, you go to work, get your job schedule, do the work and then go home. You are paid for the time you work and you receive benefits that the employer may offer. 

Working for yourself, you have to get the work, schedule the work, do the work, collect for the work, do the bookkeeping, process payroll, pay the bills, get the permits, do the advertising, meet with the inspectors, secure insurance for the company, pay the taxes, etc. etc. In other words, when you go into business for yourself, everything falls on your shoulders, at least initially. That’s why it’s foolish to say that you’ll work fewer hours as your own boss than you would by working for someone else.

Here’s an eye-opening calculation that I learned from my father many years ago. Take your total income (wages/salary/bonuses, etc.) and divide that number by the number of hours you worked that year. The result will be the amount you earned for each hour you worked (hourly wage). According to the Bureau of Labor & Statistics for the U.S. Department of Labor, the median wage of a plumber in 2010 was $22.43 per hour ($46,660 annually). That amount is based on a standard work year (2,080 hours).

Now, let’s look at a self-employed contractor. Realistically, you’ll be working at least 60 hours a week (3,120 hours annually). At the median wage of $46,660 a year, that works out to $14.94 per hour. You would have to earn $69,982 for the year to be at the median wage of $22.43 per hour. That amount doesn’t include overtime pay. Most plumbers and HVAC technicians don’t think about this as they’re having that entrepreneurial seizure. Why would you go into business for yourself to work more hours for similar pay with all of the additional responsibilities and liabilities? You’d be setting yourself up to fail.            

So, what can be done to reduce the rate of failure for start-up P-H-C contracting companies? Let’s start by teaching these individuals the basic financial skills needed to run a successful contracting business. So we’re all on the same page going forward, we’re going to start with terms and definitions.

What is accounting?

It’s the system of identifying, recording, summarizing, verifying, analyzing and reporting the financial information of a company. Or, as I like to say, “keeping score” in your business. There are a number of terms and theories that are important to gaining an understanding of accounting. They include:

Accounting Equation is the relationship of the company’s assets, liabilities and owners’ equity. It’s the basis for the double-entry bookkeeping system. It’s expressed as:

                                    Assets = Liabilities + Owners’ Equity

This equation must always be in balance. Always.

Assets are the things a company owns. Examples: cash, inventory, accounts receivable, vehicles and goodwill.

Liabilities are the debts the company owes. Examples: accounts payable, payroll taxes payable and loans payable.

Owners’ equity is the amount of assets left over after all the liabilities of the company are paid. It has a number of components to it. It includes:

Capital (sometimes referred to as Common Stock) is the amount of money the owner initially contributed to the company as well as any other amounts invested at a later point in time.

Retained earnings are the accumulated profits and losses of the company since the company was started. The balance is adjusted based on the profit or loss for the company each year.

Draws/Distributions are a separate account created to track amounts distributed to the owner from the company. Other times, these are simply tracked through the retained earnings account.

Balance sheet is a financial statement that summarizes the company’s assets, liabilities and equity at any moment in time. This is the accounting equation shown in a statement form.  

The purpose of the balance sheet is to connect things to people. It shows you the things you have in your business. Then, it connects those things you have to the people who own them or have a claim to them. It’s like a snapshot or picture of the business because it relates to a specific point in time of the business. Contractors used to get balance sheets for their company from their accountant or bookkeeper once a year or maybe quarterly if the contractor requested it. Now, with the advent of computer software, you can generate a balance sheet at any point in time and as often as you want.  

A balance sheet shows you what you own and to whom you owe, but it does not tell you everything that happens in a business. We need another scorecard (financial statement) to tell us what happened in the business over a period of time. It’s called an income statement.

Income statement (or Profit & Loss statement or Operating statement) is a financial statement that tracks the sales (revenue or income) and expenses (costs) of the company over a period of time (typically a month, quarter or year). While the balance sheet is like a snapshot or picture, an income statement is like a movie.

Here are some important terms and equations to understand on income statements. Let’s start with the income statement equation. It is:

Gross Sales – Sales Discounts & Returns = Net Sales – Cost of Sales = Gross Profit – Operating Expenses = Operating Profit – Other Expenses + Other Income = Net Profit

Let’s define these terms. They include:

Gross sales (revenue or income): This is the total amount of products and services sold before accounting for any discounts or returns. It is also referred to as the “top line” on an income statement because it is the top (first) line on the income statement.

Sales discount: These are the amounts the company allows the customers to deduct from the amount owed for prompt payment. This account also accounts for coupons used by customers on work performed. It is deducted from gross sales to arrive at net sales for the company.

Sales returns: These are the sales amounts that are returned to the company for a credit or refund. Of course, it doesn’t happen often for services performed. This total is also deducted from gross sales to arrive at the net sales amount.

Net sales (revenue or income): This is the total amount of products and services sold after accounting for any sales discounts and returns.   

Cost of sales:You may also see this referred to as Cost of Goods Sold. However, since we primarily sell services, it is Cost of Sales in our industry. These are the direct costs attributed to the work performed and materials sold by the company. Cost of Sales includes:

·  Materials(purchases): This is the amount of materials purchased by the company less any discounts received from suppliers.

· Direct labor cost:This is the amount of labor paid to actually perform the work (i.e. amounts paid to plumbers and HVAC technicians).

· Direct labor burden:These are the taxes and benefits associated with the wages paid to the plumbers and HVAC technicians. It includes: employer’s portion of Social Security & Medicare taxes, federal and state unemployment taxes, workers’ compensation and benefits paid to those employees.

· Other direct costs:These include: job permit fees, equipment rentals for jobs, subcontractor costs and miscellaneous job expenses.     

Gross profit: This is the amount that’s left after subtracting the Cost of Sales from Net Sales.

Operating expenses (overhead or indirect costs): They are the costs to maintain the business that you have whether or not a job is sold. They are the costs that you cannot assign to any specific job. You can’t directly charge a customer for an overhead expense like for repairs made to a service truck. For example, the service truck breaks down in Mrs. Brown’s driveway. You can’t charge Mrs. Brown for the cost of the truck repair because it broke down in her driveway. You have to spread that repair cost (as well as all of the other overhead costs) over all of your jobs (all of your customers). Each customer would pay for a portion of the repair via the overhead component of your selling prices.

Operating profit (operating income): This is the amount of gross profit left after subtracting the total operating expenses. It’s the profit generated from the operations of the business. It is often confused with Net Profit.

Other income: Income earned by the company not directly related to the operation of the business. It includes: accounts receivable service charges, investment and interest income, gains on the sale of business assets and miscellaneous income.

Other expenses: Expenses incurred by the company not directly related to the operation of the business. It includes: interest expense, income tax expense and losses on the sale of business assets.

Net profit (net income): This is the amount left after adding other income and subtracting other expenses from the operating profit. It’s commonly referred to as the “bottom line” because it is the bottom line of the income statement.

The net profit amount is added to the retained earnings balance on the balance sheet. If the company incurs a net loss then the amount is subtracted from the retained earnings balance on the balance sheet. These two financial statements are connected to each other. The bottom line of the income statement is added to retained earnings (if a net profit) or subtracted from retained earnings (if a net loss).

The foundation of an understanding of accounting is built by knowledge of the terms, equations and financial statements used in business. Once the foundation is set, we can build upon it to better educate the plumbing & HVAC contractors on the financial aspects of owning a successful business.

In the next installment of this series, we’ll explore the income statement in more detail. We’ll take an in-depth look at overhead expenses. I’ll share with you the number one overhead item in any company as well as the most often overlooked and misunderstood overhead item.

Michael Bohinc is a Certified Public Accountant in Cleveland, Ohio, and the owner of Keeping Score Inc. He has served as the Chief Financial Officer of Norhio Plumbing Inc., his family’s plumbing company in Aurora, Ohio, since 1988. He also currently serves as the Interim Director for the Service Nation Alliance – Plumbing Group. You may contact him via e-mail at: [email protected].

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