Optimize Your Organizational Structure to Eliminate Waste, Increase Profit

2009 Article SeriesLet’s face it. People make your business “go.” No matter how automated or established it may be, it’s your people – or call it your talent, human capital or human resources – who pull the strings. They give it life, adaptability, innovation, customer service and personality.

Labor (talent, human capital or human resources) is very expensive. So to manage a profitable business, the human resources must be continually optimized. You need to keep your human capital fully productive and engaged. Stretch a human resource too thin and you lose effectiveness. Important jobs go undone or underdone. Underuse or under-challenge a human resource and you waste labor dollars.

For these reasons, organizational analysis should be one of the first tasks of your cost reduction and/or profit improvement program.

The objective of organizational analysis is to determine how company duties can be streamlined and/or reorganized in such as way as to cut cost and enhance productivity. Some of your people may have too much on their plates. Others may have too little. Certain tasks may be better performed by one person in your organization than another. You should be very clear as to who accounts for the greatest amounts of revenues and expenditures. Revenues must be continually enhanced, costs must be continually purged, and people with the greatest impact on the organization’s performance should report directly to the owner.

Three Rules for Optimum Organizational Structure

In designing your organizational structure, adhere to these three key rules:

1. Span of Control: A manager should supervise close to the optimum number of employees. In administration, the span of control for an executive should be from five to nine persons, with seven being optimal. Fewer than seven and the executive may be underused. More than seven or eight and effectiveness may be compromised. Resources may be spread too thin and inadvertently, hinder profitable performance. In the plant, a foreman can maintain control of up to 15 persons, each handling complicated operations; 50 or more if each handles simple operations.

2. Proper Reporting Level: Employees whose departments have the greatest impact on profit should report directly to the owner*. Typically, it’s the heads of marketing, sales, manufacturing, purchasing and finance/accounting. For some companies, the head of engineering could be included. For others, quality control or risk management.

* We assume the owner is the top manager of the business. If this is not the case, substitute CEO, president, GM, etc. for “owner.”

3. Management Insulation: The number of levels between the company head and the lowest level of supervision should be kept to a minimum. This is not just because it will reduce cost (fewer managers needed) but because layers erode the quality of information that flows from the front line to the top manager. The top manager depends on the flow of information to make wise decisions. In addition, it becomes more difficult for the owner to assess individual performance when multiple layers separate him or her from “the doers.”

Organizational analysis is simple when you keep these three principles in mind. But before you do it on your own organization, let’s apply the skills to a little company called PDQ.

Case Study: Take a look at the following organizational chart of a small manufacturing company called PDQ.

PDQ Organizational Chart

PDQ Organizational Chart

Is it optimized for labor productivity and efficiency?

Consider the three rules described above. Does it conform, or can you develop a structure that more closely adheres to the three rules?

I think you can do better. So, just as you would restructure your own company’s organizational chart, take a pen and paper and lay out a new org chart for PDQ.

Keep in mind, there’s not a single right answer. We’re just looking for a structure that appears to conform to what we know about efficient and effective organizational structures. Of course, organizational charts should be developed in light of the strengths, weaknesses, experience and capabilities of the various players in the organization, and we don’t have all of this “color” on PDQ, so just make some assumptions and come up with a structure that appears to be an improvement. Take a minute to do so.

Have you done it? Resist the temptation to just read on. Reorganize PDQ’s org chart and then return to read the rest of this article.

Stumped? Here are some observations that might help you get started.

Span of Control: It appears from the organizational chart that the president/owner avoids management responsibilities a bit. I guess she can have it any way she wishes, but it would seem that her talents are underused. Only one direct report!? In addition, several managers have just one or two direct reports. It appears that the managers are underused.

Proper Report Level: If it’s smart for the owner to keep direct tabs on the persons who impact profit the most, the current structure seems suboptimal. In most manufacturing organizations, the purchasing manager spends a significant amount of the company’s money and thus has a great impact on profit, but PDQ’s organizational chart does not even show who is in charge of purchasing. Further, manufacturing managers typically have a significant impact on the bottom line, but PDQ’s manufacturing manager is several layers removed from the top manager.

Management Insulation: This one’s glaring. The owner of PDQ, as it is organized, is a full four levels removed from her manufacturing labor and sales personnel. This is silly (and ineffective and wasteful) for a company of just 15 people.

So can you devise a better structure? Can you eliminate some personnel expense? Reduce the amount of management insulation? Decrease the number of managers and increase the number of direct reports?

Okay, your work is done. You’ve reorganized the org chart of PDQ. How much money did you save?

On the next page, you will find our reorganized and optimized organizational chart for PDQ Company. Just because it differs from yours does not mean that yours is wrong. There may be more than one right answer, but the one on the next page accomplishes some important things. First, it reduces payroll a full $250,000 per year ($80K reduction in direct labor, which lowers COGS (“Cost of Goods Sold”), and a $170K reduction in overhead labor, which lowers SG&A (“Sales General and Administrative”) expense. To put it in perspective, look at PDQ’s Income Statement before restructuring.

Revenue $3,800,000 100%
Cost of Goods Sold $2,356,000 62%
Gross Profit $1,444,000 38%
SG&A $1,262,000 33%
Operating Profit $182,000 5%

A $250,000 reduction in payroll expense is a very big deal. In fact, it will increase PDQ’s operating profit 137% – taking it from $182,000 to $432,000! Operating profit margin rises from a paltry 5% of revenue to a healthy 11%. Here’s what the new income statement will look like, all other things being equal:

Revenue $3,800,000 100%
Cost of Goods Sold $2,276,000 60%
Gross Profit $1,524,000 40%
SG&A $1,092,000 29%
Operating Profit $432,000 11%

How did we do it?

First (ad-libbing a bit for illustration purposes), the owner of PDQ agreed to get in the management game a little more directly. That is, she agreed to increase her direct reports from one to three. This important move allowed us to eliminate the general manager, who earned a whopping $100K.

Second, we got the CFO to directly oversee manufacturing operations. For that, we gave him a raise from $75,000 to $95,000. The CFO will now oversee accounting, purchasing AND manufacturing operations. He will report directly to the president/owner, which is much more appropriate. The CFO also gained the title of purchasing manager. Indeed, he now has a lot on his plate, but the key to making this work was our assumption that one of the four manufacturing laborers could step up and become manufacturing team leader. We increased this person’s pay from $40,000 to $50,000. Our net savings is now at $70K per year.

Third, getting both the CFO and one of the manufacturing laborers to step up a bit allowed us to eliminate a second manager – the manufacturing manager – which saves another $90,000 per year and takes our total saving to $160K.

Next, we got the marketing manager to take on management of the sales team. This allowed us to eliminate the sales manager (another $90K per year, taking our savings to a whopping $250K). Surely the marketing manager can handle his marketing duties and also manage the sales team. As an incentive, we promoted him to vice president of marketing and sales and moved him up to report directly to the president/owner. He did not get a pay raise but was promised one if he excels.

Finally, we moved the business development manager directly under the president/owner. The rationale was partly to lessen the load on the new VP of sales and marketing, and partly because of the significant impact the position can have on revenue growth. Further, the owner of PDQ likes business development, and this new structure will allow them to work together more easily and, she hopes, achieve better results.

New PDQ Organization Structure

org_chart_21

A couple of points in closing. First, reductions in labor costs are just one potential value in an optimized organizational structure. Our discussion above happens to focus on this type of benefit, but a substantial benefit is developing an organization built for maximum productivity. In other words, an optimal organizational structure will result in higher revenue and profit per employee and higher profit margins overall.

Second, keep in mind that people like to be busy. Boredom is a terrible thing. Do your employees a favor and challenge them. Give them a lot of responsibility. Give your managers a lot of direct reports. Reduce the number of layers between you and the lowest rung. The result will be lower cost, greater efficiency, higher levels of satisfaction, lower employee turnover and, most important, improved profit margins.

Now, pull out the organizational chart for your business. If you don’t have one, develop one. Even draw it up freehand.

What does it look like? Are there obvious breaches of our three rules? Does it look lean and mean, balanced? Or does it look lopsided? Out of balance? Do some people have little on their plate while others are covered up? More layers than necessary?

Of course, we don’t suggest that our three rules are hard-and-fast, but give them good consideration. Could your organizational structure be improved?

Note: This article was adapted by David L. Perkins, Jr. using, in part, information contained in The Cost Reduction and Profit Improvement Handbook, 1983, Harry E. Figgie, Jr. The techniques presented are as applicable today as they were 30 years ago. Harry Figgie spent his career reducing costs and enhancing profit in private companies. After graduating from Harvard Business School in the 1950s, Figgie specialized in profit enhancement at various organizations, including Booz Allen, Firestone, and Parker-Hannifin. He then put his skills to work for himself by buying a distressed manufacturing firm that was doing $20 million in annual revenue. He applied his techniques with great success. He then bought another, and another, wringing profit out of each. Over a 30-year period and some 50 small-company acquisitions, he amassed an organization with revenue of $1.4 billion and hundreds of millions in annual profit. Although later in life his giant company began to falter, business owners can learn a lot from what Figgie did so well – wring profit out of private companies through a thorough approach to cost reduction.

This article originally appeared in The Business Owner Journal, the periodical of choice for owners of small and midsize private businesses. All rights reserved, D.L. Perkins LLC. © 2014.

This publication is intended to provide general information on the subject matters covered. It is sold and distributed with the understanding that neither the publisher nor any distributor or advertiser is engaged in providing legal, tax, insurance, investment or other professional advice. The advice of a qualified professional should be sought before any reader applies a concept presented herein to his or her particular situation or business.

D.L. Perkins, LLC is solely responsible for this content.


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