[EDITOR’S NOTE: VITAL holds monthly CI Business Mastery Classes where it addresses important CI business topics via a webinar. Each class is supported by an industry brand. VITAL has agreed to share some of the information from these classes in a monthly column of highlights from its most recent webinar. The ninth CI Business Mastery Class was on overhead, and it was supported by Masimo/Sound United.]
This month, we are going to discuss what we consider to be overhead, how much of that overhead we can control, and what are the true threats around overhead and other things that can put you out of business. For this discussion, the overhead we are going to be talking about is major operating costs.
In the VITAL method, we have three categories of major operating costs, and all the business expenses go into categories under these three headers.
1. Sales expenses tend to rise and fall with revenue, or they tend to be put in place to drive additional revenue. These expenses include marketing and sponsorships, and they can be the largest of the three expenses.
2. Occupancy expenses tend to be fairly fixed, and they relate to the space we occupy. We monitor them so that we can gain insights into how we’re leveraging the space and those expenses as we grow. We’ve come across many dealers who own their building under the company name and thus have very little stated occupancy expense on the P&L, as the mortgage is paid on the balance sheet. Their profitability is overstated because they are not showing rent on their P&L. Not only is that an unrealistic profitability picture, but you get better asset protection and the ability to value your business and real estate separately if you organize it in a different way. We recommend, for several reasons, that your property is owned under a completely different LLC or company and that it is rented to the business at a market rate. Consult with trusted tax and legal counsel for your situation.
3. Admin expenses also tend to be very fixed regardless of how much work is being done or how much revenue is being generated. These are typically your fixed expenses that are required to operate the business and are not categorized already as Sales or Occupancy expenses.
The overall benchmark for the total major operating costs is 10 to 18 percent of revenue. That’s a big swing and can be very market dependent. The best-performing dealers are able to leverage these costs to produce larger revenue and profit outcomes, which is the key to managing your major operating costs.
Manage As You Go
A common misconception is that we can cost-cut our way to profitability, but simple analysis shows that it is incredibly difficult to do because you end up starving the business of the things that it needs to produce value to its customers. And producing value is what allows you to charge a premium for the work that you’re doing.
The absolute best way we have seen to manage fixed expenses is to assess them as they’re incurred, being diligent to manage those added expenses. As you grow, profitability is leveraged when you’re able to increase the output of the company without a corresponding linear increase in fixed expenses. As for those variable expenses, they tend to rise and fall with revenue activity, and you can also manage those as you agree to them.
Think about leveraging all expenses as much as possible, including reducing your cash outlay each month for things like leases, fuel, and vehicle maintenance. You have control over those things. It might be small, but you can increase your profit a quarter of a percent, a tenth of a percent, one-half of a percent at a time, and that all adds up. In a $3 million business, one-half of a percent of increased profit is $15,000. At the end of the year, it’s over $1000 a month.
The moral of the story is to be diligent and manage those expenses as they’re agreed to, ensuring that you can see a return on investment as leverage against the expense.
Four Reasons Businesses Fail
Can I overhead myself out of business? Major operating costs or overhead represent a small percentage of the expenses in your business. Ideally, when it’s managed well, it should be less than one-third of your payroll costs. We’ve yet to see anyone in our industry go out of business due to overspending on fixed or variable costs. It’s really hard to do that. What we have seen are businesses going under due to these four reasons.
1. Gross Margins: I know you may be sick of me saying this, but this is the most controllable situation in the business. You set your prices, yet this continues to be the biggest miss for dealers across the industry.
2. Payroll: We must have a 30 percent wedge between gross margin and payroll. Otherwise, it’s hard to have a double-digit or better net profit. Many of the dealers we’ve spoken to who’ve gone out of business were hesitant to make the difficult decisions needed around personnel when things got tough or cash flow became a concern. If you’re stuck in a situation where you have more work that needs to get done, but profitability and cash are a concern, it goes right back to number one: poor margins. You’re not making enough money to begin with.
3. Cash Flow: Cash is what determines the overall solvency of a business, and all too often we see poor cash flow leading to doors closing even in the best of times. It is critical to understand how much of the money in the bank is yours, what is committed to completing future projects, and how much is necessary to maintain a healthy business operation.
4. Poor Work: Simply not doing great work and having to overspend on getting that next job, then dealing with the ebbs and flows of job timing, can easily lead to disaster in a business. We have seen it where the marketing spend is so high to overcome the lack of repeat and referral business that major operating cost numbers are out of control. And we have definitely seen that lead to some concerns of cash flow, which then leads to downfall.
It is important to note that there are differences in overhead across the country. The biggest pattern that we see across our VITAL client companies is that, regardless of their compensation and overhead, they’re able to produce significant profit because they are pushing the levers that produce better outcomes. So, don’t let your market concerns lead you to believe that you can’t produce the outcomes that are possible. We see it day in and day out across the entire country.
You must implement changes in the business and be disciplined, but it can definitely happen.
For more information about the CI Business Mastery Classes and the other services VITAL provides, visit http://growwithVITAL.com.