Zero Margin Issue Revisited

We reported on the impact of handling warranty parts, at cost or no profit, in an article titled “The Impact of Zero-Margin Warranty Parts” in ASN last summer.  Because of the importance of this subject, and the impact it has on your bottom line, we felt it appropriate to re-visit this concept.  In this article, we will offer a different approach, although very similar to that last piece.  This will show the effect on your bottom line, in real dollars.  

Here we will approach the subject based on income statement analysis.  To use this approach, all you need to know is how your sales break down in a given period, labor versus parts.  And additionally, you will need to know your costs for each.  This information should come right off of your Income Statement if it is structured properly.  If you do not have easy access to this information, then the first order of business is to get setup to do so.  

So, let’s begin.  We will assume this company had gross sales of $100,000 in this reporting period, and the breakdown of labor and parts is indicated in Fig 1. 

Let’s further assume that this company performs 30% warranty service.  That means that 70% of his business is non-warranty and 30% is warranty.  We will also assume that the parts sales are the same, 30% warranty and 70% non-warranty.  In the real world, this company would most likely find their parts sales closer to 40% warranty and 60% non-warranty.  This is because you will find with warranty service, more parts are used and the cost per part is usually higher.  So, our estimate here is conservative.  

As you can see in Fig 1, this company does very well with a 10% profit.  This business owner believes life is wonderful.  But if he is like most owners, he hasn’t paid himself yet, so maybe this 10% is not as good as it seems.  Let’s look further.  

If you go to Fig 2, all we have done is separate the parts information from the whole Income Statement.  The Sales amount and Costs of Sales are already determined.  What we are doing here is assuming that if 40% of our total sales are parts, then 40% of our Operating Expenses has to do with parts.  This is a common accounting procedure for costs analysis.  You could refine this assumption by looking at your Operating Expense categories and making adjustments.  For example, you could argue that auto maintenance, insurance and fuel is not a valid parts expense so you could back that out.  Having gone through this exercise, I have found that you may adjust this total by as much as 5%, by eliminating non-parts expenses.  For simplicity, I will not make any adjustments and use the 40% as indicated in Fig 2.  Including the expense of $16,000 now leaves a loss of $2,000.  Ouch!

What we have done so far is separate the “Parts” information on our Income Statement and assumed a share of Operating Expense equal to the parts percentage of sales.  This is easy to do and a very good starting point to evaluate the impact of your parts handling on your overall operation.
 

The next step is to separate your parts into warranty versus non-warranty columns, still maintaining the Income Statement format.  There are no new assumptions made here.  This company happens to double the cost on all parts to establish a retail price and as always the case when doing warranty service, the sales price of warranty parts is the cost, “Zero Margin.”  Simply spreading this information out, as indicated in Fig 3, demonstrates the impact of handling warranty parts.  In this case, the $4,800 loss in the Warranty Parts” column is the cost of handling the warranty parts.  This is real dollars that you came up with, somewhere else, to cover this cost.

In this case, the manufacturer would have to pay a 40% handling charge for you to break even.  I am not advocating here that manufacturers pay a 40% handling charge on warranty parts, but clearly something needs to be done.  Arguments can be made about the assumption that 40% (Parts) of your sales generates 40% of your expenses.  Remember the billing and collection process for warranty parts is significant.  I would argue that you will find the cost of handling warranty parts to be very close to the Operating Expense percentage you see on your Income Statement, if structured properly.  

Traditionally, the manufacturers will say that this expense is built into your warranty labor rates.  If that were the case, warranty labor rates should exceed your COD labor rates, but we know that is not the case.  The fact remains that we cover that expense through COD sales.  Looking at your Income Statement, imagine what you have to sell to generate $4,800 to cover this.  This doesn’t mean that all you need to do is sell another $5,000.  It means that you must sell another $48,000, with no increase in costs, to be able to do this.  And saying that creates a whole new set of arguments.  No matter how you mix things up, there is a considerable expense here, and it is the responsibility of manufacturers to acknowledge and correct this situation.  Your IRC is working on that. 

Warranty service must be profitable, and coming to grips with the “Zero Margin” issue is a giant step in the right direction.