Why is calculating Absorption Rate so important for Equipment dealers?
Guest writer Tom Montgomery writes about absorption rates as a measurement tool in this week’s blog post, “Why is calculating Absorption Rate so important for Equipment dealers?”
Absorption Rate Calculation has been a measurement tool used by equipment dealers since the 1960’s. It is still a valuable measurement today.
In my work with equipment dealers all over the world I have found that the dealers that I consider to be on “the leading edge” measure their absorption rate every month.
This measurement tool is driven by the senior management of the dealership – it is not to be taken lightly. When senior management finds that the rate falls below their standards they immediate action to improve it.
Absorption Rate Calculation – here is the definition!
It is the percentage of dealership expenses absorbed by the gross profit generated from Parts and Service sales.
Sounds easy doesn’t it!?
Not so fast!
Dealer’s accounting methods vary greatly.
One example is the way the cost of goods sold is calculated in the Parts department. There are some dealers that include the cost of freight in the cost of goods sold to determine gross profit in the Parts department.
Is this the correct method? Many dealer principals insist on including all costs associated with running a Parts department. I believe it is the dealer’s choice. Most importantly, the dealer should be consistent in their measurements.
Another accounting variance among dealers is the calculation of Service gross profit. There are dealers that include all “benefits costs” in the calculation of cost of goods sold.
Again, if that is the choice made by the dealership then remain consistent every month.
Other dealers chose to account for this as an expense. What is the correct method?
The answer to that is found in another question.
What is the dealer trying to measure by calculating absorption rate?
The answer is, “Will the gross profit coming for the Parts and Service departments pay the expenses for the dealership”?
Some dealers might ask, “Are there any expenses that should be excluded in the calculation or is it all dealer expenses?”
Great question!
How should “interest expense” and “allocated expense” and “administration expenses” be treated”?
The dealer must be certain that interest, allocated and administration expenses are reasonable, controllable, and justifiable?
What does that mean?
Interest rate should be associated with accounts receivable and accounts payable (but exclude interest on mortgages).
Allocated and administration expenses should not exceed 10% of sales.
So, what is the target for Absorption Rates?
Is it 80%, 90% or 100%?
The answer is 100%!
Why 100%?
The dealers should want all expenses to be “absorbed” by the Parts and Service departments.
What advantage does the dealership gain if absorption rates are at 100% or greater?
- It allows the Sales department to be more competitive in the marketplace.
- There are numerous ways for a dealership to increase absorption percentage. The first thing that dealer principals may rely on to increase service absorption is to write more repair orders for higher amounts — sell more service.
- Tweaking pay plans, training service writers, changing processes, and focusing on recalls make sense, but a great way to get a jump in absorption is to focus on your used equipment inventory.
- Everyone in the equipment business already knows that used equipment sales generate more gross profit than new equipment sales, but sometimes they forget that the used equipment department should be the service department’s top customer.
- That will start a sales cycle that will grow labor and parts sales and allow the sale of service contracts that increase future service absorption.
- Lastly, loyal service customers is a constant producer of labor hours and parts sales for the used equipment department.
- It’s important to support the service department through your used equipment; it will make the equipment more saleable, road-ready, and at the end of the day, the extra money will not affect the gross profit but will affect the bottom line for the service department.
- The dealership’s goal should be to recondition more equipment in less time, because getting the equipment in the dealer’s inventory sooner will increase sales and profit for all three departments (Parts, Sales and Service).