The Two Levers of Profit

Step #12 - in the 20 Steps to Build a Great Business

 

The 2 Key Numbers/Metrics to Profitability - Simple Numbers.

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There are two key levers to profitability in any business. If you want to increase your profits, begin to understand, track and measure these two "numbers" and your profits can soar.

Those two "numbers" are Gross Margin and Labor Productivity!!!

Most business people look at labor as the biggest expense item on their P&L. They budget it based on raises and benefits, etc. and then don't look at it much during the year. It is an expense to them.

Stop right there - that belief is a lie and one most business owners fall prey too.

 

Begin right now to look at the total cost of your labor as an INVESTMENT and one you expect a great return on. What do I mean by an investment? Take The Container Store for instance. 30 years of unheard of profits and compounded growth of 20%.

The secret?  Kip Tendall, the founder, will tell you simply "We hire the best people, pay them 30% more than the industry average, but those A Players are so productive that we have 1/3 the number of staff in each store as the industry average."

He treats labor as an investment so it does not matter how much he spends on it only that he gets a great return on that investment. He does not, as most business people,  treat labor as an expense looking to cut it to make more profit.

So look at the productivity of your people - Full Time Equivalents - using Revenue per FTE or better still, read the following...

From Greg Crabtree, author of Simple Numbers:

Revenue gets too much credit and Gross Margin is misunderstood and measured incorrectly.

A company that focuses on revenue without profit is like the First National Change Bank skit on Saturday Night Live.  "Four quarters for a dollar, how do we make profit? Volume!"

A company that focuses on the Gross Margin percentage instead of Gross Margin dollars will quickly find there are not enough foolish customers in the world that overpay for things to support their uncompetitive business.

This blog is about how to get the two brothers to play nicely - and about why Gross Margin dollars is a higher quality number than Revenue.

Revenue is certainly the starting point of every P&L statement, but I contend that many businesses over-emphasize revenue. Each revenue dollar is not equal when it comes to the Gross Margin you get after your direct costs.

Definition of Gross Margin

I have a slightly different definition of Gross Margin than most accountants.  Gross Margin is Revenue minus all direct costs that do not include labor.  A direct cost (commonly referred to as cost of goods sold or cost of sales) is any cost that is directly associated with the production of revenue.  Easy examples are:

• merchandise cost that a retailer sells
• materials for a construction contractor
• a subcontractor for a government contract

Other business models might not be as easy.  For example, an IT services business might include subscriptions to software tools that they resell to their customers as part of their monthly service fee.  The key to what you include is to be consistent in putting the cost in the same place.  Many times, we model out for a client the presentation of the data as a direct cost and then show them the same data within Operating Expenses to see which one resonates best.  With our bucketing approach to our Simple Numbers Tool, it makes it easy to change which bucket you put it in before you have to commit.  At the end of the day, it is more about where it makes sense for you than the accountant!

Why Not Include Direct Labor?

I have long contended that since labor is the key driver of profitability in your business, you never want to mix labor with anything that is not labor.  This required us to create a new subtotal after Gross Margin and before you get to Operating Expenses.  Gross Margin minus Direct Labor is what we call Contribution Margin.  Contribution Margin is the true "output of the business engine."  By keeping Direct Labor on a separate line, it allows me to quickly hold Direct Labor accountable to Gross Margin.

Gross Margin Dollars Holds Direct Labor Accountable 

Every type of labor has a number that it is held accountable to.  Our measurement of "Direct Labor Efficiency Ratio" or "Direct LER" is Gross Margin divided by Direct Labor.  This ratio gives me the multiplier effect of my Direct Labor instead of the common calculation of looking at labor as a percentage of something.  My experience says people would prefer to be considered a multiplier instead of a fraction.

If you measured your Direct Labor against Revenue instead of Gross Margin, you would get significant distortion if you sold goods or services at different margin percentages.  This is why I never recommend the "Revenue per FTE" metric.  (FTE = Full Time Employees) Revenue dollars are not equal if they come at different margins, and certainly no two employees are equal.  A Gross Margin Dollar is the highest quality number for true income and a Dollar of Labor is the highest quality cost metric to measure it against.

Gross Margin Strategy

By focusing on Gross Margin Dollars, you open up your mind to different business models.  We had a client who sold a high cost item on the Internet at cost just to get profit from high margin accessories and make a profit on shipping.  His goal was to make $800 of Gross Margin per customer interaction, not maintain a GM%.

Once your Gross Margin as a percentage of Revenue drops below 40%, you may want to consider basing all of your profit metrics off of Gross Margin instead of Revenue.  We typically push up the target percentage if we use Gross Margin, and it is not unusual for those businesses to make 20%+ net Profit as a percentage of Gross Margin.  The key challenge with a high volume, low GM% business model is making cash flows work out.  If you can fund your cost of goods with either vendor money or your own money, these can be very lucrative business models.

As a service business, I currently do not have any cost of goods sold in my model, but I leave the line there because I could choose someday to resell other people's services, subcontract out some work or sell product.  It may or may not fit your values or focus, but it is good to leave open the possibility should the right situation come along.

Summary

Measure Revenue as a starting point, but make Gross Margin the true top line of your business for internal discussions.

The Leadership Planning Process and Document

Step #11 - in the 20 Steps to Build a Great Business

 

The Leadership Planning Process and Document

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"You read a book from beginning to end. You run a business the opposite way. You start with the end, and then you do everything

 you must to reach it."

- Harold Geneen, industrialist

 

 

Strategic Planning is a must for ANY BUSINESS. You must have a place to document and write the story of your business. In 30 years of corporate life I have been a part of dozens of strategic planning meetings and the documents or "books" that usually followed those meetings. 100% of them were put on a shelf and never looked at again for a year or more. The meetings were good, but the documents were too long, complex and just not fluid enough to be used. We could not execute with them.

 

I found a simple document, that is great for the small business. It is a document that is part of a process, has everything in 2 pages, is updated quarterly and is a living plan that requires execution and accountability. Here is a 10 minute video taking you through this document.

 

https://youtu.be/Q8Zkl_Gz1Oc

 

I have a new online coaching Class starting Nov 15^th. This course is a 6 month mini MBA with you and your company as the case study. You will learn and take action on that learning to build your plan and learn how to ensure it is executed.

Questions about the class? Click here for Answers.

Culture Eats Strategy for Lunch

Step #10 - in the 20 Steps to Build a Great Business

 

Culture Eats Strategy for Lunch. Core Values and Why They Matter.

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"Researchers found it actually doesn't matter what your core values are. What matters is that you have them and you align the entire organization around them; and you're willing to hire and fire people based on having nothing to do with their actual job performance."

- Tony Hsieth, Zappos

 

Watch this 7 minute talk by Tony Hsieth about Core Values and Purpose. And then read this short article on how powerful it can be for your team and business.

The All Blacks

Most of us are not in tune with Rugby but the All Black's are the best in the world and have been for 100 years.

I saw this article and thought it was a great example of Core Values and how, when defined, embraced, communicated and lived every day can ensure a great company with competent, committed and engaged employees.

When England faces the All Blacks on Saturday, they will line up against statistically the most successful sporting team in human history. New Zealand's win-rate over the last 100 years is over 75 per cent. It's a phenomenal record, and an achievement matched by no other elite team, in any code.

But back in 2004, something was wrong. The 2003 World Cup had gone badly, and by the start of the following year senior All Blacks were threatening to leave. Discipline was drunk and disorderly, and to make things worse, the All Blacks were losing.

In response, a new management team under Graham Henry began to rebuild the world's most successful sporting team from the inside out. They wanted a fresh culture that placed emphasis on individual character and personal leadership. Their mantra? 'Better People Make Better All Blacks'. The result? An incredible win-rate of just over 86pc, and a Rugby World Cup.

In early 2010, I had the privilege of going deep inside the All Blacks camp for five weeks alongside photojournalist Nick Danziger. It was a unique opportunity to study the way the best in the world stay on top of their game.

Here are five lessons in leadership I learnt.

The All Blacks Values

1. Sweep the sheds (Rick- sounds like 2 Second LEAN to me!)

Before leaving the dressing room at the end of the game, some of the most famous names in world rugby - including Richie McCaw, Dan Carter and Mils Muliana - stop and tidy up after themselves. They literally and figuratively 'sweep the sheds'.

Former All Black Andrew Mehrtens describes it as an example of personal humility, a cardinal All Blacks value.

Though it might seem strange for a team of imperious dominance, humility is core to their culture. The All Blacks believe that it's impossible to achieve stratospheric success without having your feet planted firmly on the ground. 

Dan Carter Kicking for Goal

2. Follow the spearhead - (My input: Hire and fire  for values, not competence alone).

In Maori, whanau means 'extended family'. It's symbolised by the spearhead.

Though a spearhead has three tips, to be effective all of its force must move in one direction. Hence the All Blacks mantra 'No D***heads' (loosely translated No one gets in that is uncommitted, disengaged, that don't "fit in"), a term shamelessly stolen from the Sydney Swans.

The All Blacks select on character as well as talent, which means some of New Zealand's most promising players never pull on the black jersey - considered d*******s, their inclusion would be detrimental to the whanau.

3. Champions do extra (My input: committed to improving you and everything around you.)

Former All Black Brad Thorn's mantra, 'Champions Do Extra', helped him become one of the single most successful players in rugby history.

The philosophy simply means finding incremental ways to do more - in the gym, on the field, or for the team. It is much like the philosophy of marginal gains used by Team Sky.

A focus on continual improvement, the creation of a continual learning environment, and a willingness to spill blood for the jersey was at the core of Graham Henry's All Black culture. 

Brad Thorn

4. Keep a blue head (My input:  keep focused on the Rocks, the right things and executing them, not putting out fires and reacting all day.)

Following their arguably premature exit at the 2003 World Cup, the All Blacks worked with forensic psychiatrist Ceri Evans to understand how the brain works under pressure. They wanted to overcome their habit of choking.

'Red Head' is an unresourceful state in which you are off task, panicked and ineffective. 'Blue Head', on the other hand, is an optimal state in which you are on task and performing to your best ability.

The All Blacks use triggers to switch from Red to Blue. Richie McCaw stamps his feet, literally grounding himself, while Kieran Read stares at the farthest point of the stadium, searching for the bigger picture.

Using these triggers, the players aim to achieve clarity and accuracy, so they can perform under pressure. 

Richie McCaw

5. Leave the jersey in a better place (My Input: Core purpose.)

The All Blacks have long had a saying: 'leave the jersey in a better place'. Their task is to represent all those who have come before them - from George Nepia to Colin Meads, Michael Jones to Jonah Lomu, and all those who follow suit. An All Black is, by definition, a role model to schoolchildren across New Zealand.

Understanding this responsibility creates a compelling sense of higher purpose. It's a good lesson for us all: if we play a bigger game, we play a more effective game.

Better people make better All Blacks - but they also make better doctors and lawyers, bankers and businessmen, fathers, brothers, and friends.

James Kerr is the author of Legacy: What the All Blacks Can Teach Us About the Business of Life. 15 Lessons In Leadership (Published by Constable £12.99) 

Find and Define Your WHY!

Step #9 - in the 20 Steps to Build a Great Business

 

What is your Why? Your Purpose? And why does it matter?

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"The two most important days in your life are the day you are born and the day you find out why."

- Mark Twain

 

From Steve Chandler:

Once you are living on purpose, your resentments will simply be obstacles in the way. You will want to clear them off the track as soon as your train slows down enough, so you can feel the power, the deep power of your life's purpose on course. Listen to what you love. Respond to what you love. Pay attention. Live consciously. Be aware of your own happy moments. When have you felt most alive? This is how you will find your soul's purpose in life. When do you get lit up? What gives you that tingle in your spine? When do you smile in spite of yourself? If you become a purpose-detective, you will begin collecting clues. Keep going there, wherever the clues lead.

 

 

Two Videos to get you started:

1. Start with WHY? Focus on Purpose and its importance in any company -18 minutes
    
2. Finding your purpose in 5 minutes

We begin by asking the most fundamental question of why the organization exists. This question aims not at determining what products or services the company offers, but focuses on what motivates people to carry out the work. The work we actually do may change through the years, but why we do what we do should last for a very long time.  The core purpose also captures the soul of the organization.

To begin discovering your Core Purpose, try using the "Five Whys" exercise.

 

Start with WHAT you do. Write the statement on a flip chart or white board: "We make X products or deliver Y services".

The goal is to ask the question until you get to the true essence of your purpose, one that can guide the organization in the decisions it makes and attracts and motivates employees to carry out the mission. 

Answer these questions in writing about your company:

 

1. Who are you?
2. What do you love to do? A Passion for, it is fun and your company brings the most value to. Why? (5 times like a 2 year old)
3. Who you do it for? Why? (5 times like a 2 year old)
4. What they want or need and what do they do when you deliver it that makes it rewarding to you?  Why?
5. How do they change or transform as a result of what you give them? Why?

 

• Ask "WHY is all of this important"? Write the answer on the flip chart or white board.
• Ask the WHY question again and again (up to 5 times), dig deeper, each time brainstorming and charting your answers.
• Review all the different answers to the WHY question with your team, searching for the answer that resonates most, generates some passion, and gets to the heart of your organization's Core Purpose.
• Here are a few good core purpose statements that have endured the test of time:
   
• 3M: To solve unsolved problems innovatively
• Merck: To preserve and improve human life
• Mary Kay Cosmetics: To give unlimited opportunity to women
• Walt Disney: To make people happy
• Next Level Coaching - To help people exceed their expectations

After you develop your core purpose, test it with your executive team for a quarter or two to determine if you have it right.  Does it resonate with why you come to work every day?  Is it enduring? Is it inspirational and motivational? Does it fit even if we change the products or services we offer? Does the Core Purpose align with our Core Values?

Understanding and developing the right Core Purpose is well worth the time invested.  It will help drive your strategy, attract the right people and give meaning to the work your people do. Good luck!

 

Your Core Purpose is for column 2 of your Strategic Plan that will stand the test of time.

To begin, ask these three questions;

1. Have we written down the Core Purpose?
2. Have we announced it to the rest of the company?
3. Does it pass the memory test?

If the answer to these questions is yes, congratulations, you are on the right path.  You still may want to dig deeper to see if it resonates with your team.  Does it motivate them to come to work and serve your clients to the best of their ability?