[EDITOR’S NOTE: VITAL is in its second year of monthly CI Business Mastery Classes where it addresses important CI business topics via webinars. 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 topics are the same as the previous year’s classes, but the content is refreshed. This CI Business Mastery Class was on the Big Two — gross profit and payroll, and it was supported by B10 Capital.]
Last month we talked about profit levers in the business and which ones matter the most, with the top two being gross profit and payroll (also referred to as compensation). These two big levers ultimately determine the success or failure of a CI business. More important, they can make the difference between a business result that’s just “good enough” or one that is truly exceptional. Today we are going to dive into these two levers and provide takeaways on how to effectively measure and improve the performance of these two areas of your business.
Last month we introduced you to the concept of blended margin. We contended that a 49 percent blended gross margin was a useful target and is a great starting point for most companies. In blended margin, we count the technician payroll as cost of goods. But this creates an issue in analyzing compensation when we’ve split up our labor and then mixed it in with costs of goods sold into gross margin. So now we’re going to introduce the concept of top-line gross margin.
Top-line gross margin is focused on the bidding work that your company does, which is where all of your profit starts. If your bids aren’t right, good luck making a profit. It also allows us to manage compensation as a single bucket that we then divide up into smaller categories of compensation.
Basically, the difference between blended margin and top-line margin is that we break out the labor wages in the top-line margin, which allows for clean management and benchmarking month after month. When we break out the labor compensation, we can also calculate labor margins, productivity utilization, and several other important metrics that help us drill down on what is happening in the production side of our business.
Top line gross margin is the revenue you collect from customers, minus what you pay your vendors for equipment and parts. A very good top-line margin is 60 percent or better. How can you improve your top line gross margin? Here are several factors that can have a huge impact with very small changes.
- Sell brands and categories that produce higher margin
- Eliminate discounting
- Charge what you are worth and stand confident in why
- Diligently track and bill change orders
- Stay on top of price changes
- Measure gross margin accurately
As an example of how even one of these factors can make a big difference on your financial results, let’s look at price changes. In this example, we will use a $3 million company that has achieved a 60 percent top-line margin, which means they’re spending $1.2 million with their vendors.
What we saw in the last couple years is an average price change of about 8 percent from a vendor. So, if you catch half of those price changes — half of them typically fall through the cracks — that’s an increase of your costs of goods sold of 4 percent, or $48,000 more that you spent on that gear than you thought you would. That’s a 1.6 percent reduction in net profit right off the top, if you did not have an increase in sale price.
Now on top of that we can add an increase in payroll. It costs more now than it did a year ago to hire, train, and retain our employees. So, if we added a 10 percent increase in wages, that’s another 1 percent hit to your net profit. That’s why you need to stay ahead of price changes. It’s also important to measure gross margin on a regular monthly basis so you know what’s happening in your business.
Payroll is the largest expense in your business and it is made up of the wages and bonuses we pay to ourselves as owners and to our employees to do all the work. Figuring out what you should be paying, how much you can afford, and what hiring decisions you should make are questions that regularly come up in your CI businesses.
Here is an example that shows how you can figure out exactly where you should be: A business operates at a 62 percent top-line margin and compensation consumes 32 percent of its revenue. It has 30 percent, or $30 of every $100, to pay other expenses and retain a profit. This is what we call the wedge. In another example, a business runs at 62 percent gross margin, but their compensation is a little higher at 34 percent of revenue. That’s not quite the 30 percent gap that we recommend, but through strict controls on their major overhead costs, they enjoy a nice 20 percent net profit margin after everyone and everything is paid. Results like this are very possible, but it takes intentional practices and disciplines inside of the business.
It’s important to frame what we mean when we say payroll and compensation. This is meant to include all payroll for the entire company, including owners and managers, as well as payroll taxes, payroll expenses, benefits, et cetera.
If the top-line margin is less than two times your compensation, then you’re likely discounting the value of your people and not charging enough. The profit wedge is another way to express this concept. VITAL’s recommendation for a profit wedge is to have a 30 percent gap between top line gross margin and compensation.
We need to produce more revenue without a corresponding increase in compensation, or we need to reduce compensation. Ultimately, that decision is made by the forecasts built into that company. Managing these results takes intention, discipline, and strategy. It is not easy. Here are some of the best compensation management strategies we’ve seen our clients implement with great success:
- Eliminate overtime
- Sales compensation should be between 4 and 7 percent
- Focus on team productivity
- Reduce windshield time
- Eliminate friction in daily dispatch and return
- Have a plan, work the plan, be intentional
If you motor toward these improvements over and over again in your organization, you will see that the change is not as hard to come by as you might think.
For more information about the CI Business Mastery Classes and the other services VITAL provides, visit http://growwithVITAL.com.