It’s a familiar story. A guy starts up a small-engine repair business out of his garage. He’s located in a rural area with a strong demand for a local repair center. He’s a service-only dealer. He’s doing a fairly modest volume. However, since nearly 100% of his income is from service labor, his gross margin is fantastic—sometimes 50% or more. He doesn’t carry any equipment lines. And, since he’s operating out of his garage, his overhead is very low. Life is good as a lower-level Tier I dealer.
Fast-forward a few years, giving this business some time to evolve. His annual revenue is now in the $600,000-$750,000 range. He’s now carrying an equipment line or two. His gross margin on equipment isn’t all that great, but parts and service margins remain strong. And because he’s still a parts- and service-dominant dealer, his overall gross margin is a healthy 30%-plus. His overhead is still low—probably 15-18% of gross, which is well below the industry average. He doesn’t do much advertising. Payroll is low since it’s him, his wife and a buddy. This dealer is likely netting $50,000-$100,000 a year. Life is great as an upper-level Tier I dealer.
Bright lights, big city
But now he’s on the radar screen. He’s showing up as a listed dealer for one or more of the engine manufacturers. He might be in the Yellow Pages. Manufacturers are starting to knock on his door. A “bright lights, big city” image is created in his mind. After all those years of hard work, sweating in his garage, he has a chance to become a legitimate business. He can add several more equipment lines and begin to rapidly grow his customer base.
This is where it starts to crumble for many a dealer. When he gets caught up in the excitement of transforming his business into a “legitimate” power equipment sales/service operation, he’s stepping away from the Tier I lifestyle that he’s grown accustomed to. He’s moving into Tier II, which has consistently proven to be difficult to manage.
The sky is falling
Typically in Tier II, which is the $750,000-$1.5 million range, the dealer has to quickly learn how to manage a growing business with a considerable increase in overhead. You need a definite strategy when you get into this middle tier. Otherwise, you can make more money staying smaller, focusing on service like you did in the beginning.
Overhead, also known as operating expenses, will typically increase 3-5%, if not more, during the Tier II phase. Taking on additional equipment lines requires more operating space. So the dealer upgrades his facility. Now there’s additional overhead in the form of rent and utilities. These are fixed expenses the dealer has to live with month after month, even during those slow stretches when revenue is down dramatically. Furthermore, since the dealer has likely relocated to a more suburban venue, operating expenses such as rent, utilities, employee wages and insurance are higher than they would be at his previous rural location.
In Tier II the employee base expands almost immediately. At this sales volume you need at least one more technician. You need a delivery driver. You probably need a salesperson to work the counter and showroom since you’re too busy managing your growing business, dealing with vendors and taking phone calls. Your wife is now busy helping you stay afloat, so you may also need to hire an office worker, at least on a part-time basis. Now that three-person staff you had during Tier I is a seven-person staff. Even at $1.5 million a year, it can be tough to carry this payroll.
Drawing the line
The Tier II dealer, so enthralled by the newfound fame of running a legitimate power equipment dealership, is typically carrying eight or more equipment lines. It’s important to carefully scrutinize the carrying costs for each of those lines: interest, insurance, property or inventory taxes, storage or floor space cost, handling costs, deterioration and theft. Obsolescence is another big carrying cost. Since the Tier II dealer is carrying so many lines, it’s probable that there’s some redundancy in inventory; carrying two trimmer lines, for example. This greatly increases the likelihood that obsolete inventory will start to mount.
Another issue arises due to the fact that the Tier II dealer is carrying more lines than he ever has before. This dealer’s inventory investment is spread across several suppliers. Thus, in many instances, he’s likely to be buying in a lower bracket, often giving him a 13-15% margin. That’s simply not good enough, especially when you consider the fact that the Tier II dealer’s overhead is typically 18-22%, with 22% being the more likely scenario.
To minimize the impact of this staunch reality and keep their businesses going, many dealers have made a few “tricks” somewhat common. First, they subsidize their money-losing lines with profits from their other lines. They may even subsidize with profits from the parts and/or service departments. Dealers who do this are about a half a bad season away from bankruptcy.
Secondly, some dealers stop paying their two or three “least important” suppliers. Dealers are supposed to sell and pay. But many don’t. Many sell and count it as cash flow. They pay back “some” manufacturers at a time. Eventually, they lose a line or two because they don’t pay. They don’t care, because they can go pick up another line if they absolutely have to in order to fill a product category. And they justify this in their minds because, “the manufacturer got me into this in the first place.”
A third way dealers minimize the impact of money-losing lines is by cutting out certain expenses in order to reduce their overhead, making that 13-15% wholegoods margin more feasible. For instance, they stop paying their wife’s salary. They don’t pay themselves rent because they own the building their dad started paying off 30 years ago. It looks like they’re making it. But they’re not. If you’re not paying yourself rent you’re not fully utilizing your assets. And if you’re not paying your wife you’re restricting your household income. She could go work somewhere else and actually earn a paycheck.
In order to escape Tier II the right way, dealers need to work like mad, which is something many of you are probably all too familiar with. You need to put in extremely long hours. You need to run lean with a staff of three to five people. You need to fight the temptation to over-expand your brand offering. You need to maintain a firm grip on your expenses. And you need to move through Tier II as quickly as possible—preferably in one season. If you can get to $1.5 million in one year, you’re out of the woods. Then, you can hunker down the next season and grow comfortably from $1.5 million.
Climbing to the top
There is no magic formula that will allow you to make this dramatic jump. A lot of it has to do with market conditions. How you market yourself also makes a difference. You will likely have to pursue business more aggressively and hire an outside salesperson to call on municipalities, institutions, businesses and contractors. Better yet, if you’re running a lean staff and carrying a more manageable number of lines, you’ll have time to be the outside salesperson yourself. Then, once you secure the additional commercial business, you can hire someone to manage those accounts while you focus on even more ways to grow your business.
Remember, Tier II brings a lot of added overhead to the table. You don’t want to increase your payroll too much and make this problem worse while the sales increase you’d hoped for is lagging. Grow the sales base yourself, and then hire someone to manage it.
Speaking of overhead, it doesn’t change all that much when you make the jump from Tier II to Tier III. You’re functioning with the same employees. You’re in the same building. Sometimes, however, the dealer will move from a B location (rent $3,000/month) to an A location (rent $4,000/month). That increased overhead is well worth it to some Tier III dealers, especially when you consider the boost in productivity and customer traffic the new location provides.
The biggest difference between Tier II and Tier III is that you can spread your overhead costs over a much broader base of revenue in Tier III. The Tier III dealer, in many instances, has learned how to shift his focus. Service and parts are high margin. Many have added a high-margin rental department. Used equipment is being managed properly and has become a nice profit center.
Typically, the Tier III dealer has narrowed his lines a bit because he wants to focus on his top three manufacturers so he can buy in the best brackets and increase his wholegoods margin. This also makes the dealer more important to the manufacturer. This dealer can actually get his suppliers to work “for” him; moving inventory to other dealerships, assisting at open houses and trade shows, etc. The Tier III dealer has leverage.
When you can reach Tier III, everything will be OK—as long as you keep your margins in line and your expenses under tight control. You can make some serious money in this business, just like you can make some serious money in Tier I. But, in most cases, if you flounder around in that no-man’s land known as Tier II for too long, you’re dead. If you’re a Tier II dealer, get a strategy in place now so you’re not the next one to bite the dust.