Why is calculating Absorption Rate so important for Equipment dealers?

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?

  1. It allows the Sales department to be more competitive in the marketplace.
  2. 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. 
  3. 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. 
  4. 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. 
  5. 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.
  6. Lastly, loyal service customers is a constant producer of labor hours and parts sales for the used equipment department. 
  7. 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. 
  8. 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).
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Does Your Dealership Measure Customer Retention?

Does Your Dealership Measure Customer Retention?

Our new guest writer, Tom Montgomery, asks a critical question in his inaugural blog post for Learning Without Scars: Does Your Dealership Measure Customer Retention?

If you had to define Tom Montgomery in a nutshell, you would say he is a powerful strategist. Tom is a business savvy professional with in-depth experience.  He is consistently able to deliver excellent results in high growth, competitive markets. Tom is a strongly analytical person with a no-quit attitude. He is a dedicated team builder and creates an environment of support and encouragement for his team members. Tom is an articulate communicator who is skilled at building relationships. He has served as a mentor to many and teaches customer loyalty skills while driving sustained revenue growth. Tom comes to us with a skill for transforming low-performing teams into high-caliber workforces. He has had a more than 40-year career in the heavy equipment industry.

During the time that I was working for one of the leading Komatsu dealerships in North America I discovered a method on how to improve profitability by understanding how often our customers bought goods and services from us. This was one of the simplest and easiest methods to create new opportunities for the dealership however very few dealerships take the time or effort to find out how. This method was a review of how successful we were in keeping our customer base loyal to the dealership.

It was all about Customer Retention!

Measuring customer retention may be one of the most important steps you can take to protect your dealership. It gives you a firm grasp on the “percentage” of your customer base who buys from you year-after-year. Learning how to measure and understand retention will allow you to take steps to improve the sales and profitability of your business. When I discovered how to track this important measurement, I was able to work magic in terms of sales and profits.

What Is a Reasonable Target for Customer Retention?

Remember, we are trying to find what percentage of your customer base who buy from your dealership on a repeat basis (historically comparing one year to the next year).

It is best to use a five-year history if you are able to do so. A reasonable goal would be keeping 80% of your customers in Parts and Service departments and 95% in the Sales department.

First Let’s Look at the Benefits to Your Dealership.

You don’t need to be a math wizard or a specialist in database management to accomplish this.

You will see how DO-ABLE this is as you read further. When I have studied dealer’s customer retention, I have found that most dealers lose at least 50% of their customer base in a five-year period. In order to survive you must find a way to replace that income or perish. One way to replace that income is to find new customers to replace those who have left your business.

However, adding new customers to your customer base is the most challenging and expensive way to survive.

There is a better way!

It is much more valuable and less costly to find ways to sell to existing customers rather than to add new customers as the sole method of making your business grow. Consider this; you have probably spent a considerable amount of time, energy and money building a relationship of “trust” with you current customers. You must “leverage” this relationship of trust to benefit both your customers and your business. It has been estimated that it costs 5 to 14 times the amount to add a new customer as it does to sell to an existing customer. Most dealers DO NOT have the resources to sustain that type of activity.

What Are the Reasons Customers Leave a Dealership?

This information comes from my study of dozens of dealerships:

  • 5% of customers leave a business because they have moved out of the area.
  • 5% leave because of changing their buying habits.
  • 10% leave because they prefer the competition.
  • 12% leave because they did not like the services your dealership provided.
  • 68% of customers leave because they believed they were treated with indifference or have felt unappreciated.

Here are a few important questions to consider.

After a customer purchase from your business how soon should you contact them with a telephone call, post-card, email, letter to say, “Thank You?” Do you have a standard practice in your business to “follow-up” on a recent purchase? Retaining a customer is nothing more than finding ways to meet and exceed the customer’s expectations. And… It is much easier to do that than to continuously find new customers.

What Is the Financial Impact for Your Dealership?

By figuring out the percentage of customers that buy from you, year-after-year, you will be able to specifically measure the “financial” impact to your dealership. Here is a remarkable fact:

For every 5% improvement in retention, you can expect a 25% to 80% improvement (or more) in the profitability of your business. Since a majority of dealers never measure customer retention you will be creating a significant advantage over your competition. It is like having a roadmap to improved profitability. Once you know where you stand you will be able to make significant changes to improve it.

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