Absorption is an important concept to understand when looking at efficiency and performance or deciding how to price goods and services in your truck parts or repair business. Get it wrong, and you can easily find yourself operating at a loss. Get it right, and you can achieve fundamental control over your profit margins.
At its most basic, absorption costing is an accounting method which can be used to explain the true cost of delivering a product or service to the customer. It means that all of the costs associated with providing a product or service have been absorbed by the time the item is sold, or a repair service is rendered.
In practice, this means that your final selling price for an item or service effectively covers every single expense associated with bringing it to the customer for sale. This ensures that your company does not suffer an accidental financial loss when providing a truck part or repair service.
By combining and tracking all of the expenses associated with bringing parts and services to the customer, you are able to get a better view of the real cost your company incurs to provide your products and services. This means, in turn, that you are better positioned to choose accurate prices, and to understand and control your real gross margins far more effectively.
The Value of Absorption Costing
Whether you are a parts dealership or an independent repair shop, selling parts and providing quality service is the lifeblood of your company. To more fully understand what makes up your absorbed expenses, it makes sense to break your accounting down to the fundamentals.
Absorption costing is a crucial concept to understand, especially when it comes to understanding efficiency or setting your parts pricing. Too often, pricing for parts is set by the original purchase price of that part rather than the fully absorbed costs which your company accrued in purchasing, shipping, storing, insuring, and handling the item. This common mistake will typically lead to improper pricing and profit loss, which is unsustainable for any company.
For this reason, it’s also good to review these costs periodically, to see if they are going up or down in response to changes within your company. Having an accurate understanding of these processes can help you identify adjustments that need to be made in a certain department, or in your accounting procedures.
How to Begin Using the Concept of Absorption
Put simply, to calculate the absorbed costs for your truck parts or repair business, you will need to include:
- A total of your material costs for production, execution, and delivery of a product or service.
- All of your direct labor costs, including the hourly labor needed to produce goods or services, plus the taxes and benefits paid to employees.
- All of your fixed expenses such as facility rent, utilities, management overhead, insurance expenses, etc., which are associated with producing an item or service.
- All your variable expenses, such as material loss, parts or repairs for tools and equipment, and idle labor.
Note: It’s common to see the absorbed costs vary from month to month, as your volume of business increases and decreases, or as efficiency increases or decreases in your company due to changes in management techniques or production. Track these changes closely to understand the variable factors which influence the cost of production and service in your repair or parts business.
How to Use Absorption to Better Understand the Variables of Your Business
Now you understand why your truck repair, parts, or dealership business should be using the accounting principle of absorption to help you better understand overall efficiency and your real costs for selling parts, or delivering services to your customers.
Depending on your needs, absorption costs can be calculated by a specific period of time, by individual parts sold, or by hour of service rendered. Each of these options is effective, depending on how you track the different aspects of your business, and what kind of business you run.
Because tracking absorption, regardless of the method you use, will help you understand what is contributing to the cost of the items and services you offer, you will be better prepared to set pricing levels correctly so you can effectively improve your company’s profit margins.
Understanding Absorption in Your Parts and Service Departments
In most pure parts and service businesses, you would want to separate the parts department from the service department in your accounting practices. This allows you to view the fully absorbed expenses of the parts department separately from the service department, since these two areas tend to have widely variable ratios of costs to income.
For example, to find the absorbed costs in a parts department as a percentage of revenue, you need to monitor and calculate the:
- Direct Cost (inventory beginning value + purchases – inventory end value divided by total sales for the period)
- Fixed Cost (total fixed costs divided by total sales for the period)
- Variable Cost (which is your material loss and all other expenses divided by total sales for the period)
When separating your parts department and service department, you may or may not also choose to break out your sales, general, and administrative (SG&A) expenses separately from your cost of goods sold (COGS). It depends on how you want to view your business, and what kind of data you need to extract out of your bookkeeping.
Smaller businesses often don’t have a separate function for SG&A, and so will want to absorb these expenses into the COGS in order to maintain gross profits. On the other hand, larger businesses will often choose to look at them as combined period expenses; to be reviewed monthly, quarterly, and yearly.
Special Considerations for Absorption Costing in Dealerships
If you have a truck or equipment dealership business, you will need to create a separate accounting function for your truck or trailer sales, and the associated expenses, so that you can review absorption in this area independently from the other departments in your company.
Because margins on truck and trailer sales tend to be very thin, dealerships often need the parts and service departments to absorb the vast majority of the operating expenses. It’s common to operate the truck or trailer sales department near break-even or at a small loss, then make it up on the service side. The only way to make this work effectively is to understand the absorption costs for each separate department, so that you can make educated decisions about how to manage income and losses for each.
Remember: Absorption can go up if business slows down, if you have to write off material losses, or if your fixed costs rise. Fixed costs can rise quickly if you hire additional people, facility rent goes up, or interest on your loans goes up.
The Importance of Understanding Absorbed Costs Per Hour of Billed Labor
Understanding absorption for your parts, service, and dealership departments is vital for controlling your bottom line. Another crucial absorbed cost to understand is the labor for your business. Employees are expensive to maintain; often more expensive than you would think when looking just at payroll numbers.
Absorbed costs for labor really only applies to the service department, and then only to the technicians that do the actual work in your service department.
The cost of an hour of billed labor to the customer needs to carry the burden of all the costs associated with creating that hour of labor. This is a key concept to understand, if you hope to control your bottom line.
When technicians are inefficient in their work or are sitting idle, variable labor costs increase significantly. Similarly, if you add employees that aren’t directly doing billable work, your company’s fixed costs go up. Likewise, if you spend money on new equipment, create increases to your facility or utility costs, or the insurance premium for your company goes up, you are faced with an increase of your fixed costs.
All of these costs must be averaged and absorbed across every hour of billable labor. As we discussed in a previous article, burdened labor is often misunderstood. Any employee in your company costs quite a bit more than their payroll. For your technicians, the cost of one employee includes their wages, taxes, uniforms, and any other benefits your company supplies.
For these reasons, calculating the true cost of labor in your company will go a long way in your efforts to leverage accurate accounting to improve the performance and profitability of your business.
Beyond basic payroll numbers, the true cost of every hour of labor includes:
- Direct Cost for labor (which is your burdened labor cost per hour)
- Fixed Cost for labor (which is the period fixed expenses divided by billed hours over the same period)
- Variable Cost for labor (which is the period warranty work + unbilled labor divided by the billed hours over the period)
Again, much like the parts department, monitoring your labor absorption costs is a crucial tool to help you understand and gain control over the profitability of your company and each of its individual departments.
As always, improving job and employee efficiency, as well as quality of the work done in the shop, will significantly improve the associated absorbed costs.
Management concepts like ‘Lean Thinking‘ can go a long way toward increasing tech efficiency and reducing the variable expenses in your company.
Similarly, improvements to your employee training program can help reduce mistakes and minimize profitless warranty work. Likewise, taking steps to eliminate idle time for your techs significantly improves efficiency.
Remember: Absorption of labor costs necessarily increases if business slows down, you do more unpaid rework on a job (warranty work), and if your technicians have more wasted idle time on the clock.
Absorption Costing – A Priceless Tool for Efficiency, Pricing & Profitability
While it can be a little tricky in the beginning to get the hang of calculating your absorbed costs, it is vital for your bottom line that you learn the technique and take a good look at the resulting data.
By incorporating this method of tracking the true cost of a part or service, you can ensure that all incurred costs are recovered from the selling price of a part or service. With this method, you will have the confidence that you’re efficient, prices are appropriate, which will in turn enable you to lead your business to long term success and profitability.
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