|
Since
the early 1960s, equipment dealerships have used the "absorption
rate" to measure how much of their sales, personnel,
administrative and interest expenses are paid for by their
parts and service operation.
Over the
past decade, though, as dealerships have become increasingly
serious about the rent-to-rent business, they've tinkered
with how they calculate absorption. This has distracted from
the measurement's original intent.
Here's
the true way to calculate absorption rate: divide the
net income of the parts and service departments by the total
expenses--including sales, salaries, administration and interest--incurred
by the sales and administration departments.
Unfortunately,
the rent-to-rent business model and the distribution business
model do not coexist. As a result, traditional measures like
earnings before taxes, inventory turnover--and especially
absorption rate--aren't particularly useful in determining
the operational effectiveness of the dealership.
The rent-to-rent
business model is straightforward. It depends on cash flow.
The asset isn't sold outright, but in pieces as the machine
is rented. Thus, asset turnover as represented by inventory
turns is of no use when looking at an effective distribution
model.
The distribution
business model is also straightforward. It depends on managing
such traditional items as gross margin and expenses.
Melding
the two models misleads management on how the business is
performing and what steps need to be taken to properly steward
the company's assets and position in the marketplace.
Absorption
is a measure that reflects a dealership's share of its territory's
parts and service markets. The dealership's pricing effectiveness
is reported in its gross profit. Expense control and profit
contribution are reflected in the net operating profit of
the parts and service departments.
The other
side of the absorption equation is determined by how well
the dealership manages its parts and service operational expenses.
If profits from the parts and service departments produce
an absorption rate of less than 50%, the dealership needs
to study administration and sales expenses as well as parts
and service revenues.
Why do
that, you might ask?
Because
the spending levels of sales and administration, and the inventory
levels as reflected by interest on debt, are also under scrutiny
when absorption is a key management measure. If expenses are
overly high, absorption can never achieve the minimum goal
of 100%.
That's
the dirty little secret of absorption.
Absorption
ties together all facets of the dealership. Sales, administrative
and interest expenses that are not recoverable from net income
of parts and service adversely affect the dealership's overall
profitability. There's not getting around that fact.
Some dealerships
try to address a rental fleet's impact on the absorption rate
by including the net income from the rent-to-rent business
along with that of the parts and service departments in the
absorption-rate calculation. They seem to think this is a
reasonable approach.
I think
not.
The best
approach is to completely separate the rent-to-rent business
from the calculation and use absorption the way it was originally
intended. The overriding question always should be: if we
use the traditional calculation in the traditional way, what
would our absorption level be? And what needs to be done to
reach the goal of 100%?
That's
what absorption is meant to do. The dealership's parts and
service profit should cover all sales, administrative and
interest expenses.
If you
aren't at 100% in the traditional manner, no amount of numeric
juggling is going to get it right. And that's the dirty little
secret about absorption.
|
