What is Your Conversion Rate?

In his book “Why we Buy,” Paco Underhill tells the story of senior executive of a multibillion dollar chain who was asked “How many of the people who walk into your stores buy something?” This executive knows a lot about his business. He knows the total sales, the average sale amount, the sales in any given store vs. last year, profitability by item, and many other things. His answer to the question was, “Damn near all of them.” Since their stores were “destination” stores he reasoned, people didn’t go there unless they had some very specific purchase in mind. The reality was 48%, which, as it turns out, is a very good rate for stores of its kind. Underhill’s book is filled with stories about how many things are “hidden in plain sight,” and how obvious some things are once we can “see” them.

The concept of the conversion rate, implying as it does that shoppers need to be “transformed” into buyers, was alien to his organization. That changed when the company realized that by changing some things about the store, they could improve their conversion rate.

Our Batting Average

Most component manufacturers I know can quote their sales figures for any given month. Sales totals and gross profit figures, viewed together, seem to be the most basic indicators of the overall health of the business. Fewer are as conscious of their conversion rate, or “Of the opportunities we had, how many bought something?” It’s the “batting average” for the business.  If we know we sold “100” this month, was it 100 out of 300, or 100 out of 1000? The conversion rate is a third very fundamental way the health of the business can be measured, and also carries with it important intelligence about the market we are operating in.

Keeping Score

If we are tracking quotes and have some kind of a way of calculating what percentage become orders, we have the basic information needed to calculate our conversion rate. We also need to know, “Among the quotes that have not turned in to orders, which are still ‘in play,’ and which went to competitors?” Even better information can be gathered if we also record why they did not become orders. Although many will go in the books as lost to “lower price,” the ones that don’t will be instructive. We might see “Couldn’t meet delivery date,” “Loyalty to other supplier,” “Project was cancelled,” “Other supplier was able to include wall panels” - and others. Gathering this information will, over time, uncover some new insights into the market. Imagine, for example, the market intelligence we’d have in observing the percentage of quotes where the “Project was cancelled” increase over time from an average of 5% a month to 15% month.

Is there any reason not to record and review “Why we didn’t get the order” or “Why we got the order” (!) on every quote? Among those lost to the competition, why shouldn’t we find out and record who the competition was that beat us out and “keep score?”

What we Might Learn

Although looking at the numbers alone would tell us some things, even more revealing might be seeing changes in the numbers over time. For example, if we see that we were getting a conversion rate of about 40% for the 3rd quarter, but it went down to 30% in the 4th, it tells us that something is changing. What is it? Has a new competitor come into the market? Is there less work out there and competitors are lowering their prices (more than we are?) If we track the fate of every quote, the reason we got or lost the job, and who we lost out to, we’d have great insight into the current market.

In a general way, we use conversion rate information to look at:

1) the extremes – the biggest and the smallest conversion rates in any sample and ask, “Why?”

2) the biggest changes over time and ask, “What’s going on and what (if anything) should we do in response?”

Which Job is Best for Business?

Let’s say we are considering two jobs that are very different. The first we’ll call Custom House. We’ve done a takeoff and we know it totals about 5200 BF, has 50 setups and 75 trusses altogether. The second job we’ll call Straight Run, and what catches our attention is that it too has about 5200 BF. But this job has just one setup and 40 trusses altogether. Straight Run has 2x6 chords, and so the lumber cost is slightly higher than it is for Custom House. We think we can sell Custom House for $8,000 and make about $2800 gross profit. We think we can get $4,900 and in the process, have a gross profit of $750. Which is better for business?

Comparing Work

Let’s put these two jobs side by side to help us with our comparison.

Custom House                                                Straight Run

5200                               BF                                5200

$8,000                            Price                           $4,900

$2,800                            Est. GP                        $750

35%                                Est. GP %                    15%

85                                   Trusses                       40

50                                   Setups                        1

$2,070                            Lumber $                   $2,510

The only thing the two jobs really have in common is the board footage. Which is “better?”

Assumptions

OK, in the current economy we may consider any job we can get as “great.” The biggest problems in recent times have been getting enough work to keep the shop operating and attempting to make any profit - “gross” or otherwise. So for the purposes of this thought experiment, I am making the assumption that we have enough work to keep our shop busy, and we simply would like some way of figuring out, “If I can only get one of these two jobs, which one would I be better off getting?” I will also be making the assumption that our production tables, not our saws, are our “bottleneck.” Stated another way, I am assuming that, “Our ability complete more jobs is limited by the production capacity of our tables.”

What’s Missing

What’s of course missing from the comparison is the time that each job will take to build. Let’s say our estimating system does not tell us how long the work will take at the tables; let’s see if we can create some plausible estimates. With Straight Run, it will take no more than 20 minutes to set up, and about 4 minutes per truss to build. That’s 20 minutes + (40 x 4 minutes) = 180 minutes altogether. In other words it will take about 3 hours of table time to complete the job. For Custom House, the most of the setups will be small changeovers, not a complete re-jigging of the table. So let’s estimate 10 minutes per Setup x 50 setups = 500 minutes. And for building time, 4 minutes per truss x 85 trusses = 340 minutes for a grand total of 840 minutes (or 14 hours) of production time. OK, you can knock holes in my math, but still I think we are coming up with plausible estimate based on reasonable assumptions. You are of course invited to put your estimating routine to work on this problem, if you prefer to do so!

Who’s Better?

The Custom House consumes 14 hours of table time and nets us $2,800; that’s $200 per hour profit. Straight Run consumed only 3 hours of table time and netted us $750; that’s $250 per hour. We are making $25% more profit by doing Straight Run than by doing Custom House. We now see the crucial elements for making good decisions about jobs coming into focus – knowing our costs and coupling them with “what the market will bear” allows us to determine estimated gross profit. If we also know “time consumed to produce,” we can then figure “estimated gross profit per hour.”

Custom House not only used up 14 hours of table time, but I would argue it consumed 14 hours of the business’ time, and is therefore liable for 14 hours worth of overhead as well. More on applying overhead to individual jobs in later articles.

Some Thoughts on Overhead

In considering a 'better pricing system,' what role should overhead play? Is it necessary to figure out overhead costs? If we've gone through the trouble of figuring out overhead costs, how should we then apply those costs in a price calculations?

Defining Overhead

I'll define overhead for the purposes of this discussion as, "Business costs not being tracked by some other process." The most common "other processes" that are accounted for independently are materials consumed and "direct" shop labor.

This definition leads us to the answer to the question, "What should we include in overhead?" by saying, "Any and all costs that are not being allocated in some other way." If direct labor is part of our pricing system, then overhead should account for everything that is not ‘direct labor.’ If there is no direct labor element to the pricing system, all costs (besides material) are 'overhead.'

Quantifying Overhead

In calculating overhead costs, one method is to move from area to area and make sure costs in each area are included. Beginning with the office, make sure each person and each office expense is included. Next, make sure that all costs associated with running the shop are included. Finally, look at expenses for the overall facility and the business as a whole. An incomplete list would include accounting costs, advertising, banding/strapping cleaning, computers, equipment leases, insurance, markers, office schtuff, subscriptions, telephone, training, travel, uniforms, utilities, vehicles, and waste collection. Have we forgotten anything? By looking through the bills for the month we might catch some things we haven't accounted for. Our goal in this process is to figure out how much money it costs to keep the business open for any given period of time (a month, a day, and hour.)

The Value

The most important reason to do all this is the awareness we gain of what these expenses are, and the realization that these costs are related to time. If the overhead expenses totaled $50,000 per month and we were only open for business for 5 hours a month, we would only have 5 hours to recover, to "pay for," all those overhead costs. If we are "open," or more precisely "producing," for 200 hours per month, we have to somehow "earn" $250 per hour (beyond labor and material)  we want to pay for that overhead. This is the reason that the most logical way to apply overhead is based on the amount of time the job will take to produce. The argument goes, "Since overhead itself must be recovered based on how many hours the business is producing each month, the only logical way to assign overhead is based on the time it will take the company to produce each job."

We will look at how to do that in later articles.