Absorption - Isn't This a Perfect Time for It? By Ron Slee
Article Date: 08-01-2008
Copyright(C) 2008 Associated Equipment Distributors. All Rights Reserved.
Let's get back to the basics of what it means.
Since the 1960s absorption has been one of the key metrics in this industry. It has almost become the Holy Grail to many dealers. The sum of the net income developed from the parts and service departments should exceed all of the expenses of the sales department, the administration group and interest. (This was before the rental business arrived on the scene.) Let’s review what this is all about.The net income of the parts and service department is pretty clear, isn’t it? One would think so until we get into how different dealers account for different things.First, the selling price for all activities in parts and service is supposed to be recorded at retail prices. This has been an item of contention for some time, so how about we clear it up. Many dealers discount (how I hate that word and action) to the sales department and other internal departments. The sales groups get subsidized by parts and service. So when absorption was first designed it was
a management metric not a financial reporting metric. Bill Blackie, the reputed “father” of absorption and former chairman of Caterpillar, required everyone to report all sales activity at retail prices. After all, he was interested in price points for equipment, too, and if different dealers reported the cost of the machine in different ways, how could anyone determine what the correct price point was for a machine? So, getting back to the calculation of net income, there is one other anomaly to eliminate: allocated expenses. The only expenses that are supposed to be applied to parts and service are the “actual” expenses they incur – not some arbitrary allocation that eliminates head office, or accounting, or the ownership – the personnel, operating and fixed expenses of the parts department and the service department.Now we move to expenses for the sales group and the administration group. First, the sales department: Eliminate all of the expenses for the rental group –they were not included in the original absorption calculation because there were no rental activities of significance when the measure
was designed. Then there is administration. One of the lessons that Mr. Blackie taught me was that absorption is not just about increasing the net income of parts and service departments; it is also about constraining expenses of sales, administration and interest. Think about it. Without controls on the expenses we can drive the dealership crazy trying to catch up to expenses that are out of control. Administration expenses should not exceed 10 percent of the sales of parts and service; after all, the parts and service departments are the transaction drivers of a dealership. The majority of the A/R and A/P and personnel activities are caused by parts and service, so the metric on cost should be tied to the sales levels of parts and service.Finally, there are interest costs. Inventories for new and used machines (exclude rental again), parts, supplies and work in process, and receivables should be the majority of the interest-bearing assets, and they should be managed as well. (I am excluding mortgages as there is such a variation on how land and buildings are handled across the industry). Inventory turnover is a real metric and needs to be managed. So is the amount of money owed in receivables. So there you have it. Net income from parts and service should be equal to or greater than the expenses of the sales department (excluding rental), administration group and interest. Simple, yet why is it that we struggle to get it done? I believe it is because we pay lip service to parts and service when we really are interested in selling machines. But parts and service pays the bills. Parts and service keeps customers coming back, or not. It’s also tough work that depends on talented, caring individuals who know how to do their jobs and who are supported with effective systems that allow them to serve customers in the manner they deserve. The market is soft, the economy is struggling, we are in the funny season of an election; and we are finding it harder and harder to attract and retain good people in all areas of our business. It’s the perfect time for a challenge – when there is a need, a fear, there’s no better time to get a “focus” on what we need to do. Get everyone working to support the changes that are needed, now.Good luck.
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