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Is your business making a healthy profit? If not, do something about it now. Something drastic. There’s no sense owning and managing a business that’s not growing and generating a healthy profit. Why mess with it? Your time and talent are worth so much more.

Moreover, you won’t survive breaking even while your competitors earn a profit. They’ll have profits to invest toward enhancing their ability to reach and satisfy customers. You won’t. You’ll fall further and further behind in your ability to compete and earn a profit.

To accept break-even or near break-even performance for an extended period of time without doing something about it is like having cancer and not seeking treatment. It’s a death sentence.

If you’re in this situation, do what turnaround expert Gary Sutton says (paraphrasing):

Take drastic action. Change the way you do business. Find a new, cheaper source for purchased goods or services. Outsource to a contractor what you’re now paying employees to perform. Focus on what you do best and get rid of the rest. Raise prices. Double the sale quota for your salespersons and let go of anyone who can’t hit the new mark. Try new, radical things, without delay. Sure, some may not work, but you’re going to die anyway if you stay on your current course. If you can’t seem to bring yourself to make these kind of changes you need to get out of the business altogether.

No Margin, No Mission

If you provide a product or service that’s competitively sold, odds are there’s a price — or price range — you have to be within to be competitive. Do you know what your competitors charge? Do you know the quality of each of their offerings relative to the price they charge? If you’re not completely sure, find out.

How does your product or service compare to your competition? What is your strategy? Is it a “we do that too” offering that competes on price? Or do you charge more but deliver more? There’s nothing inherently right or wrong with either strategy; you just need to know which is yours and whether you can succeed at the one you select given your particular competencies (or that of your company) relative to those of your competitors.

If you’re not profitable, something is amiss. It might make sense to find out what customers think about your product or service. About how you rate compared to your competition. Then ponder your competencies, those of your competitors, and the strategy that gives you the greatest odds for high profit. A third-party consultant might be helpful.

Do you require a premium price but offer a “me too” product? Do you try to offer a premium product but not charge a premium price?

For example, if you try to compete on price, it does not make sense to offer a premium product. The only way to earn superior, profit-winning sales with a low price is by having the lowest cost structure. This requires you to wring cost out at every turn. The result, of course, will not be (and cannot be) a premium product or service. Similarly, the only way to earn high profit offering a superior product is by charging a markup that’s greater than the extra cost you incur when adding the extra value.

Only through skilled execution of a clear, appropriate strategy can you earn profits that exceed those of your competitors. Legendary business strategist Michael Porter refers to a lack of strategic clarity as being “stuck in the middle.”

Pricing as Product

Sometimes, innovations in pricing can be as important as innovations in product. Take Xerox. Despite the breakthrough technology, its newly introduced copy machines were not selling. The machines were very expensive and executives did not grasp how they could reduce cost. Amazingly, business managers seemed okay with the way they were making copies: secretaries typing with carbon paper. What turned the tide was an innovation in pricing as significant as the product. Xerox stopped requiring up-front purchase and began charging by the copy. It placed its machines in large offices for free and charged for copies. No executive approval was required and office personnel quickly grasped its utility and productivity. Usage grew and Xerox revenue exploded.

Another example is Gillette razors. Competitors sold “the handle” for $20 and then cartridge refills for a few bucks. Gillette began giving away “the handle.” Men obviously liked getting it free. All they needed were refills, so they bought them. Gillette razor usage exploded, as did revenue.

Pricing innovations can be as important as product innovations. Maybe your next breakthrough can be an innovation in price. Maybe your customers would rather pay for what they really want, such as a copy or a shave, instead of paying for “a copy machine” or “a razor.”

Opportunity and Peril in Average Cost Pricing

If you manufacture custom items, you bid jobs. If you bid these jobs on average cost, you have variances from actual. On some jobs, your average cost model builds in too little profit; on others, too much. The result is that you tend to win most of your underpriced bids (which yield lower profit) and lose most of your overpriced (higher profit) bids.

Obviously, this is a problem. You book a lot of low-profit jobs and fail to capture jobs that, had you not overpriced, you could have won at your target profit margin.

The solution? Find a way to gain the ability to more accurately estimate cost. To be able to bid on actual cost rather than average cost. You’ll earn a higher profit and put your competitors at a competitive disadvantage.

And here’s another problem. If you average cost and your competitors study your bidding history and figure out which types of jobs you underbid and overbid, they could exploit the error in your costing for their own gain (and your loss), for example, allowing you to win jobs you tend to underbid and scraping extra profit from jobs you tend to overbid. On the other hand, you could do this to your competitors (if you develop an ability to estimate cost more accurately than your competitors do).

Markup-on-Cost Pricing

This article is the final one of a series on cost reduction and profit enhancement strategies. We hope you’ve implemented the recommendations and wrung considerable cost from your operation. But be careful if you price by percentage markup-on-cost. Don’t give away all your savings! Take the following example:

Column 2 above illustrates what can happen if you strictly apply a percent markup-on-direct-cost following a cost reduction campaign that succeeded in wringing most of the cost savings out of direct costs (as opposed to SG&A). The third column illustrates an approach that would be much more logical and beneficial. The cost reduction campaign allowed this sample company to reduce the price from $17.33 to $16.00 and also increase the bottom line profit per unit from 5 percent to 24.4 percent.

Pricing your products and services is complex. It can also be confusing and frustrating, but it’s essential to your ability to complete effectively and earn a profit.

What and how you charge should match your overall strategy. If your strategy is to offer a low price, you should not add bells and whistles but rather lower your costs. Conversely, if you attempt to deliver superior value, you must charge a premium (to recover the extra cost you incur).

How you price and charge is as important as any other issue you deal with. An innovation in pricing can be as important as an innovation in product or service. So come on! Outsmart and outwit your competition through skilled pricing and earn superior profit. If you think about it, it’s not even really a choice. It’s a requirement for ensuring the long-term viability of your business.

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The skill of a company in procuring (i.e., purchasing) parts, product and managing inventory can be the difference between success and failure. This is because:

1. The profitability of a business — or lack thereof — is established by the gross profit margin. That is, the profit left over from each sale after the direct expenses are deducted. For many businesses, the primary direct expense is procured product.
2. Inventory ties up a significant amount of cash in many businesses. Poor inventory management can drain a company’s cash, raise financial risk by requiring higher levels of borrowing, and erode profits due to outsized inventory spoilage, obsolescence or theft.

ABC inventory control is a relatively simple, widely used way to wring out cost, improve gross margins and increase inventory turns. Increased “turns,” of course, lower the amount of inventory-on-hand. If inventory-on-hand can be lowered from $500,000 to $300,000, the result is $200,000 in positive cash flow. If the business uses the accrual system of accounting for tax purposes, the windfall doesn’t trigger tax.

80-20 Rule: Focus Where You Can Have the Most Impact

The ABC inventory control method derives both its simplicity and effectiveness from the 80-20 rule. So, to begin to understand and apply ABC inventory control, the business owner should begin here: 80% of a company’s revenue is derived from 20% of its offerings. Every business owner should know which of his/her products or services produce the lion’s share of the revenue and profit.

Additionally, within this 20% you should learn what components make up 80% of the cost of these products. As Harry Figgie says in his The Cost and Profit Improvement Handbook, “These are the parts that make up the largest share of the company’s material costs.”

Armed with this basic information, the business owner can sit down his/her purchasing manager and begin looking for ways to lower cost and reduce the amounts kept on hand.

Divide and Concur

Building on the simple 80-20 rule, ABC inventory control methodology calls for each purchased item to be separated into one of three groups: A, B and C. “A” items are those relatively few that represent the highest cost and generally the greatest investment. As such, these items should be given considerable attention so:

• stock levels of these expensive items are minimized so the cash tied up in inventory is kept as low as possible, and
• stockouts of these items are rare despite the low levels maintained on hand

Conversely, items that cost the least are categorized as “C” items and can be purchased much less frequently, such as once per year. Doing so will reduce the time required to deal with ordering (and thus free up time to focus on A items) and render little financial consequence because the total dollar amount is insignificant. Of course, all other parts are labeled “B” items. These items can be ordered in smaller quantities than C parts, maybe monthly or quarterly, but much less frequently than “A” parts.

The accompanying table shows a sample breakdown of purchased items divided into categories A, B and C. The table also contains the basic data used to sort them. As you can see, four of the 30 inventory items (13%) have been designated “A” parts and account for 88.7% of total annual purchases (in dollars). Eighteen of the 30 (60%) have been designated “C” parts and account for just 1.8% of total annual purchases. The balance (8 of the 30 or 10%) are “B” parts.

Laid out this way, it is easy to see the simple logic: 89% of this sample business’ costs come from just 13% of its purchased items. Focusing on this subset will greatly simplify the purchasing and inventory management tasks. And, by focusing on the few that will yield the greatest results, the results can be significant. It entails minimizing the on-hand count of these items, frequent monitoring of stock levels for each, and frequent reordering. The high cost of these items provides the return on the extra time spent.

The C items account for a full 60% of the purchased items but consume less than 2% of the costs. It makes no sense spending much time on these items, so they should be set up to require minimal effort. Typically this means buying just once or twice a year.

The accompanying table labeled “Inventory Reduction Examples” shows how the ABC method can drastically reduce the amount of cash tied up in inventory. Here, a 62% reduction of the cash tied up in inventory.

Margin Improvement

In addition to inventory reduction and the important positive cash flow impact that a reduction can provide, ABC is a powerful tool for helping the business owner determine where to focus his/her energies to successfully wring out cost and improve gross profit margins. With the simple analysis provided, the number of inventory items that require cost reduction focus is cut by 80% or 90%.

Time, of course, is scarce for all of us. Scarce for our employees as well. This is the power of ABC inventory control methodology. By knowing where to focus, one can gain a maximum return on one’s investment of time and energy. The result can be the very survival of one’s business, or the difference between just getting by and making some real money. After all, 20% of the businesses make 80% of the profits. Apply ABC inventory control to your business and you’ll be well on your way to the top 20%.

Note: This article was adapted by David L. Perkins, Jr. using, in part, information contained in “The Cost Reduction and Profit Improvement Handbook” by Harry E. Figgie, Jr.

This article was written by the experts at The Business Owner. If you are the owner of a private business, go to www.TheBusinessOwner.com or call us at (800) 634-0605 for more no-nonsense how-to information.

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Profitability is driven by productivity. You want to increase profits, so your task is to maximize productivity, which is basically a measure of output per dollar of capital deployed. It does not matter what percentage of your dollars (aka capital¹) is spent on labor or equipment; the task is the same — to maximize yield.

Two elements drive productivity:

Use rate — total time units a person or machine is in productive use, divided by total time units of observation time.

Example 1: Bulldozer #224 was used 52 hours over the past 14 days, a use rate of 15.5% (52 divided by 336), assuming that a bulldozer, in theory, could be used 24 hours a day.

Example 2: Tim Tomer was observed 100 times over the past three months; 61 times he was working productively. His productivity rate was 61%.

Output rate — units of output produced by a person or machine, divided by time of work or operation.

Example: Bulldozer #224 moved 87 cubic tons of material during the five days ending September 22. Workdays were eight hours each, so #224 averaged 2.175 cubic tons of material per hour of uptime during this week.

The focus of this article is assessment of use rate. If a business assesses and tracks its use rate and takes steps to increase use, productivity increases and profits improve.

The way to assess use rate is work sampling. It lets you identify, through observation, the percentage of time employees and/or equipment work productively. If it’s equipment, “working productively” depends on what the piece was acquired to do — mold parts, pump water, take pictures or be rented out. If it’s a person, “working productively” means “doing the task the person was hired to do.” It could also be defined as “doing a task that generates revenue or leads to generation of revenue.”

Note: Herein we use the terms productivity and use rate synonymously, to a degree. When we assess people, we talk of productivity. When we assess equipment, we talk of use or usage.

When a company uses work sampling to assess its productivity it is referred to as a work sampling study. Employees and/or equipment are observed repeatedly, over a defined period and, at each observance, the productivity of each person or piece of equipment is recorded. It’s simple in concept, but to garner meaningful and reliable data, the methodology must be soundly developed and executed.

Work Sampling in Practice

Joe Smith, owner of ABC Construction, was not happy with his firm’s unprofitability. His efforts to identify the cause and therein fashion a remedy led him to look into his employees’ productivity. Do they work efficiently? Do they stay productive throughout the workday?

He decided to make an objective assessment. He located and consulted with a work sampling expert to design the program and consult on implementation. Once the plan was developed, Joe met with his employees to explain the initiative. He explained what would be measured, who would do the measuring and in which situations. Joe emphasized to the employees that this study was to improve company-wide productivity and profits and that a more productive, profitable company would mean more job security and higher profit distribution bonuses. Assessment of individual employee performance was not the objective.

He also explained to his employees:

Work sampling process. Work sampling is a series of instantaneous observations of work-in-progress done randomly over a specified period. These observations, known as samples, are compiled to show the percentage of the day workers perform productive work.

Identification and definition of work categories. Each observation or sample would be recorded in one of three major categories: productive, supportive or recoverable.

• Productive: Defined as “getting the job done.” For example, if the observed is a draftsman, he or she is drafting. If it’s a doctor, it’s working with a patient. If it’s a salesman, it’s talking to a customer or prospect.
• Supportive: Defined as any activity that is required to maximize the time that can be spent getting the job done. For example, if the observed is a draftsman, he or she may be cleaning the drafting table, updating the software, talking to a client or taking continuing education classes. If it’s a doctor, it may be inputting client information, taking continuing education classes or talking with his/her nurses about a patient plan. If it’s a salesman, it’s writing notes from a call, writing a letter or proposal to a client, or studying competitor data.
• Recoverable: Defined as “not adding any value at all or contributing in any way to getting the job done.” For example, whether the observed is a draftsman, doctor or salesperson, the observation should be recorded as recoverable if the observed is talking to someone on the phone about non-work matters, using the restroom, taking a “smoke break,” talking to co-workers about non-work matters, playing solitaire, or waiting unproductively because “the computers are down.”

Methodology. Employees are told they will be observed but not when. Observers follow preplanned routes, and the study continues until the predetermined number of samples is collected. Each time an employee is observed is one sample. It is the observer’s responsibility to document what the employee is doing when the observation takes place. The observer must document the activity based on the predetermined work categories as he or she proceeds through the job site tour. Was the action productive, supportive or recoverable? Each employee may be viewed multiple times, depending on the length of the study and how many observations are needed.

How many samples are needed? It depends on the level of confidence desired, the allowable margin of error and the current ratio of productive to unproductive time. You can easily figure out how many samples you need to get results with a 95% confidence level and a low 3.5% degree of error by:

1. Taking an initial sample of 30 observations and determining the percentage of time occupied in productive use for the sample.
2. Looking in the table below for the number of samples needed, based on results of your preliminary sample.

For example, Joe took 30 samples (i.e., 30 routes around his facility) and calculated the productivity rate at 7% (i.e., productive time plus supportive time). Using the table (top right column), he needs his full study to have at least 578 observations.

Evaluating Results

Computer software can analyze work sampling results. In most cases, observers record the work by hand on worksheets and input the data into a Microsoft Excel or similar spreadsheet software. There are also some new programs that let you record the data directly into a smart phone.

But the study results do very little for you. It’s up to you to use the data to your advantage. How?

First, share the results with your employees. Simply helping them understand how “little distractions” add up should help improve productivity.

Second, talk to your observers about the types of distractions they saw. Then develop ways to eliminate them.

Third, conduct follow-up sampling studies and compare results. Consider devising company-wide goals and rewards for improvements in productivity.

_{1 Capital also can be parsed into two types: debt and equity.}

For more information or help with a work sampling project, contact one of the following:

Jack Greene, Jackson Productivity, 843-422-1298

Nelson Lee, Laubrass, 513-624-6629

The basics of business are not very complex. Institutions, organizations and individuals have a virtually insatiable need for “stuff.” The concept of business is simply to “make the stuff” and sell it to them for more than the costs you incur. Similarly, the basics of business management are pretty simple. Find ways to continually sell more at a profitable price and cost structure.

Oversimplified? I don’t think so. There’s value in keeping a focus on the big picture. Organization-wide productivity analysis is a “big picture” analysis of the overall productivity and profitability of a business. It’s easily performed using information that’s readily available. Just gather the following:

Annual Revenue

Annual Gross Profit

Annual Operating Profit

Number of Employees

Total Annual Payroll Expense

Total Annual Non-Payroll Operating Expense

Once you have these data, just make seven calculations:

Revenue per Employee

Revenue per Payroll Dollar Spent

Revenue per Non-Payroll Operating Expense Dollar Spent

Gross Profit per Employee

Gross Profit per Payroll Dollar Spent

Gross Profit per Non-Payroll Operating Expense Dollar Spent

Operating Profit per employee

Here’s an example. Stunner Rumblers, LLC manufactures noise machines. They’re like Harley-Davidson motorcycles without the wheels. Just put your Stunner in the back of your pickup or park it in any pedestrian area of your choosing and for one-fourth the cost of a Harley you can disturb the peace just the same. Stunner’s owner, Curtis Stunner, gathered the following data on his business:

At our suggestion, he then made the seven calculations:

Now these calculations by themselves don’t reveal a lot, but put in context they’re immensely revealing. Two contexts, really — historical/trend and peer comparison. So we sent Mr. Stunner back to gather prior-year data. We then loaded it into a spreadsheet, made the calculations and created charts to provide a graphical depiction. See the results at the bottom of the article

The table and graphs clearly show the progress Stunner has made the past five years. The business is really hitting its stride. And by maintaining these data in future quarters and years, Curtis will be able to keep a close watch on the productivity of his business. Stunner should share these data regularly with his employees and post the table and graphs on the wall. Make improvement a game that everyone plays.

Peer data are essential

Just knowing your own performance can become immensely valuable. That is, if you put it to use in an effort to improve performance. But a critical question is, what are other companies similar to yours achieving? Maybe if you know that other firms were operating more productively, you’d be even more focused on improvement? Maybe it’d give you more confidence that you could improve? Maybe even vastly improve?

To be sure, Stunner would not be able to find another company that makes the same products, but virtually any specialty manufacturer of gas-powered consumer recreational equipment would provide a meaningful comparison. And Stunner would want to compare itself to others of similar size. The best place to look for these types of data is your trade association.

Yes, there are other ways to assess organization-wide productivity, but the revenue and profit-based methods are the easiest. This is because we all already track revenue, profit, employee counts, labor and operating expense. Furthermore, revenue and profit get us close to that king of kings — cash.

Productivity can also be assessed using non-financial means, such as the number of units produced per employee per hour. We’ve chosen to use this article to focus elsewhere.

One could also assess productivity directly by simply observing and recording the percentage of time that employees actually work as opposed to sitting idle, fixing a problem, taking breaks and handling personal matters. The next issue of The Business Owner will address this topic — work sampling.

Click Here for Full size of Chart

Click here for Full size Graph

 

For most businesses, profits are down. Revenue is down. No doubt, valuations based on profit or revenue are down. So if you’d like to increase your ownership percentage, would you like to buy when the price is high or low?

Low, of course.

So how about now?

Just food for thought. Of course, if your partners also hold this right and could buy you out at a predetermined formula price, don’t show them this article!

2. View your statements side by side. Decide whether you want to work on improving every line item/department or just a few key ones. It makes sense to focus on the ones that have the biggest impact on the bottom line. That is, the largest revenue- generating areas and the largest expense areas.

3. Design your spreadsheet. Enter the pertinent historical income statement data as in the sample CFS spreadsheet on page 4 that accompanies the cover article in this issue (Internal Benchmarking).

4. Identify the historical-best line-item performance for each line item. Circle or color them for ease of visual identification (as we did with the CFS sample).

5. Create your pro forma “best of” income statement. Take care to transfer the correct type of data – dollars or percentage of revenue. Revenue and fixed-expense items should be plugged in as dollar figures. Costs of goods and variable expenses should be plugged in as percentages of revenue.

6. Assign one person to each line item you wish to tackle. Make it clear. Make them accountable. Give them the support they need.

7. Investigate strategies for hitting the “historical best.” Every line item will need a strategy, execution of strategy and rigorous monitoring.

8. Track results and pay incentives for success. It’s out of sight, out of mind. Make the effort and the results part of your daily and weekly routine. It won’t be comfortable at first, but stick with it.

The primary reason for the continued rise is twofold:

1. People’s willingness to pay for health care is virtually limitless, so health care providers continue to roll out more and more expensive tests, treatments and procedures.

2. Insurance companies foot most of the bills, but patients and doctors determine the treatments, so there is little incentive to keep costs down. The only recourse for insurance companies is to raise rates.

These things you don’t control. But you DO have some control over the cost of YOUR health insurance, and of the insurance you provide your employees. It’s pretty simple.

Healthy people are cheaper to insure. Similarly, unhealthy people are more costly to insure.

Now, who doesn’t want to be healthy? Who would not like to be in an environment that makes it easier to be healthy? So do what makes sense for both you and them. Care about yourself, your business and your employees. Develop a wellness program. It’s a win-win.

Research shows that health and wellness programs reduce medical costs and lower absenteeism. Yes, you’ll spend a little money on the program, but studies show that for every dollar spent, you’ll get between $3.50 and $6 in return. That’s a heck of a return on investment.

It Starts with You
It starts at the top. You must design the program (or have it designed), participate in it and lead it. For it to work, you need to get excited about it. Sell it, enlist participants, track progress and keep the fire burning.

As The Wellness Councils of America say, “Nothing spurs attendance at an aerobics class like the chance to see the boss lead the exercises.”

How to Get Started
Creating a wellness program is not as difficult as you might imagine. The Wellness Councils of America recommend the following steps:

• Appoint a wellness team to oversee the effort. At a small business, this might be a single individual, even the boss, but involving employees is the best bet. Let it be their project. Let them get creative and be accountable for results.

• Collect data. You can’t change what you can’t measure. Data collection can run the gamut, from having employees participate in health screenings to weighing the entire workforce on a grain elevator scale to establish a weight-loss benchmark.

• Create a simple plan with simple goals. If excess weight is the primary concern, your employees might set a goal of losing 500 pounds in 12 weeks. Or if resting heart rate is the target, plan to reduce the workforce total by 50 points.

• Choose the appropriate intervention. This could be anything from providing information on healthy eating to arranging for exercise time at work.

• Create a supportive environment. Replace unhealthy drinks and snacks with healthy ones. When you go out to lunch together, make it a healthy place. And it’s important that you make it clear to workers you approve of and support their participation.

• Carefully evaluate outcomes. If the desired result isn’t being achieved, it may be necessary to make the environment even more supportive. More fun. Get a key leader involved. Post the results. Peer pressure is okay and a powerful motivator. Use it by posting individual results.

Make It Fun!
Make it easy for employees to behave in healthy ways. Encourage them to walk during the day at lunchtime and breaks. Buy inexpensive pedometers and challenge employees to walk 10,000 steps a day – equivalent to five miles. Of course, this means that you must lead the pack and set the right example. At the end of each month, reward the top male and female workers. Maybe a $25 gas card or the right to leave work one hour early.

Offer classes in aerobics or other activities that promote health and reduce stress. Maybe join an athletic league for softball, basketball or volleyball. These are sports that allow anyone to participate.

Secure membership discounts from local fitness centers for employees who decide to join. In addition, bring in certified fitness trainers for a blood pressure fair. It involves just a simple setup in your conference or break room. Most workers are unaware of their own blood pressure and how it increases with weight gain and stress. At least once a year, sponsor a health screening for employees.

Big Cost Reductions
In 2002, a U.S. government report revealed that companies with physical activity programs enjoyed a 20 percent to 55 percent reduction in health care costs, a 6 percent to 22 percent decline in short-term sick leave and a 2 percent to 52 percent increase in worker productivity.

Yes, the costs of health care and health insurance will almost certainly continue to rise, but you do have some control over the costs you bear for yourself, your family and your employees. So instead of lamenting, try implementing. Take some action. Start a wellness program for your company. You’ll find that it’s fun, builds camaraderie, reduces turnover and sick leave, adds to your bottom line and actually improves lives. What more could you want?

1 According to the U.S. government’s National Health Statistics Group, as reported by CBS Radio News.

Who doesn’t?

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Would you like a proven profit improvement technique that’s simple and requires neither outside consultant nor third-party tool nor report nor MBA degree? We’ve got it: internal benchmarking.

Internal benchmarking is a simple method to determine your company’s profit potential. All you need is your own historical annual income statements. By analyzing each statement, line by line, you can identify the best historical performance by line item or department. You then can use the information to work toward putting all of your best line-item performances into future years. The result will be a vastly improved bottom line.

The logic is simple. Your bottom-line profit is what’s left over after all the expenses have been paid out of revenue. So why not focus on each line item? If each is managed to hit a desirable target, the bottom line will take care of itself.

Here’s How

To show you how, let’s walk through an internal-benchmarking analysis for Chester Fields Corporation (CFS). We gathered the most recent five full years of income statements for CFS and lined them up, side by side, as in the table on page 4 titled CFS Internal Benchmarking Worksheet. We created it by loading income statement data, by hand, into Excel. We added percentage fields ourselves, too. Each year’s percentages are calculated with total revenue as the denominator.

Due to space limitations, we used summary income statement data. Of course, you can go into as much detail as you wish.

Analyzing the spreadsheet, we identified and circled each line item when it was at its most favorable. Then in the far-right column (i.e., the pro forma “best of” income statement), we plugged them in. For revenue line items and four of the six expense lines, we used the dollar figures (as opposed to their percentage of total revenue). [Percentages next to these items were calculated using revenue for this "best of" pro forma.] For revenue sources, we used dollars because we want to hit the best potential revenue number all in the same year (or future years). Revenue drives the business. For Sales and Marketing and Travel and Entertainment expense line items, we used percentages of revenue because they vary, at least to some degree, with revenue.

For cost of goods line items (Materials, Labor and Direct Overhead) we used percentage of revenue (instead of dollars). [The dollar figure has been calculated using the percentage and pro forma total revenue.] This is because these expense categories are variable. That is, they vary with revenue. As sales are made, expenses must be incurred to deliver the product or service.

Similarly, for four of the six expense line items (Payroll, Rent and Utilities, Office Supplies and Misc. Office and Professional) we plugged in the dollar amounts. This is because these expenses are fixed (i.e., they do not vary much with revenue).

Show Me the Money

If you’ve done it before, you should be able to do it again, right?

Based on our analysis, CFS has the very real potential to do $1,420,000 in revenue and put $223,110 on the bottom line – a full 15.7% operating profit margin. This compares to a five-year high-water mark of $66,000 in profit and 5.5% operating margin.

How can this be? Simply by managing each line item to hit the historical-best line-item performance. Nothing new required whatsoever.

Easy? Maybe not, but definitely doable.

Get Focused, Rally the Troops

The beauty of internal benchmarking is that it’s low-cost, relatively easy and effective. It can be your beacon of light for continuous improvement.

Yes, a key question will be HOW to hit your new line-item targets. The first step is to do the analysis. Then investigate how you achieved the desirable performance in that line item that “best” year you identified. For that task, get your employees involved.

Next, get your spreadsheet – just like the one for CFS – printed in wide format. Place it on the wall. Assign a single person to each line item and make it his/her responsibility to hit the target. Tell them that they have 100 percent support from you and the rest of the team (and make it so). Provide bonus incentive for results.

Track performance by month and year-to-date, and watch the momentum build. You’ll develop line-item fanatics. Revenue enhancement missionaries. Cost reduction hounds. The result will be a soaring bottom line.

The interesting thing is, the art of the possible is about envisioning the future, but humans really only move into the future by peeking into the past. It’s just the way we work.

By way of explanation, to envision what is possible we rely almost exclusively on two things:

Our own past performance

Others’ past performance

Virtually every development on earth is incremental. Evolution is incremental.

In sports, records are broken every day – in tiny increments. To break a record, the athlete’s challenge does not require him/her to create a new reality. The athlete is not required to deliver a never-before-in-history performance. The bar is set much lower – simply edge current reality by a hair.

Consider as well that each of us is heavily influenced by psychological barriers that, by their very nature, are not real. They exist only in the mind.

Take the 4-minute mile as a case in point. Though generations of runners clipped second after second off the 4-minute-mile record without interruption – and steadily approached the 4-minute-mile mark – there was a widely accepted belief that it was not humanly possible to run a mile in fewer than 4 minutes. And so, as world-class milers approached the 4-minute-mile mark, the pace slowed. The only explanation for this is the psychological barrier. Self-doubt, if you will.

Runners came closer and closer to the mark, and then it happened. In 1954, Roger Bannister finally posted a time that began with a 3 (3 minutes and 59.4 seconds) and, in the ensuing months, the rest of the field burst through with their own times under 4 minutes.

So goes the business world. Business people are obsessed with learning the accomplishments of others. Why? Because we are unsure of whether we can do such and such until we see that someone else has.

If you can, then maybe I can. And when we meet someone who accomplished X, Y or Z, we’re further emboldened. Why? He/she doesn’t look any more special than me!

Peer Benchmarking is about looking at what other companies similar to yours are doing. If you, as a business owner, can match the best of your peers in key categories such as inventory turns, collection rates, gross profit margins, labor productivity, etc., then you will secure your place in the 20% that enjoy all the spoils. Where do you find peer data? Try your industry, trade association or the Risk Management Association (formerly known as Robert Morris Associates).

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You want to reduce cost and improve profitability, but doing so takes time. And it’s not like you don’t have anything else to do. So where is the low-hanging fruit? Where can your efforts produce the highest yield?

The answer is pretty simple. As cost-cutting legend Harry E. Figgie, Jr. explains in The Cost Reduction and Profit Improvement Handbook, just lay out your income statement as follows*:

PDQ Company Income Statement

* We have deviated here a bit from what Figgie presented in his book.

All we have done here is to lay out the most recent full-year income statement for PDQ in a way that shows the major expense categories. Then, next to each expense category we’ve listed the percentage of revenue that each consumes. For example, Material Expense consumes $1,750,000 of total revenue of $3,800,000. By dividing $1,750,000 by $3,800,000 we get 46%.

Dollars of Expense/Total Revenue   =   Percentage of Revenue

$1,750,000/$3,800,000   =   46%

So pull out your income statement and organize it this way. Or ask your accountant to do it. Once you have it in front of you, consider this: You have brought in X dollars of revenue. A pretty big number, huh? Now scan down and see where all that money goes. Finally, what is left over at the end? Not much!

In the case of PDQ, $3.8 million comes in each year, but after it runs the gauntlet of outstretched hands, just $182,000 – a mere 5% of every dollar – remains. So it’s plain to see who wins here – the pilferers. The vendors.

But no more. Today we fight back, and we start where the greatest amount of ground can be captured. In the case of PDQ, it’s Material Expense by a landslide. Material Expense consumes 46% of every dollar of revenue. Reduce this expense by 10% and you’ve put an additional $175,000 on the bottom line.

Think it’s not possible? Think again.

Future issues of The Business Owner Journal will provide techniques for reducing the “cost of goods” expense, but the purpose of this article is to provide a technique for identifying where to focus your cost-cutting energies at the outset of your expense reduction campaign.

Again, in the case of PDQ, here’s its priority ranking:

1. Material Expense (consumes 46% of every dollar)
2. General and Administrative Expense (consumes 25% of every dollar)
3. Direct Overhead (consumes 9% of every dollar)
4. Marketing and Selling Expense (consumes 8% of every dollar)
5. Direct Labor (consumes 7% of every dollar)

Material Expense provides the low-hanging fruit, followed by General and Administrative Expense. Again, if you can reduce Material Expense 10%, your effort yields $175,000 and nearly doubles the bottom line. In the same vein, if you focus on reducing Direct Labor costs and succeed in reducing them 10%, you’ve generated $25,000 in additional profit.

Cost Reduction vs. Growth

Every business owner should keep in mind that a dollar of expense contributes almost a full dollar to the bottom line. This is because it generally costs very little to reduce costs. Sure, maybe some management time and effort, but the expense is negligible. But a dollar of revenue added is not nearly as valuable to the business or the business owner. In the case of PDQ, just 5 cents of every dollar of revenue falls to the bottom line. PDQ management hopes to increase that to 10 or 15 cents, but so long as expenses can be reduced in a business, expense reduction will have far greater impact on the bottom line.

What kind of expense reduction is achievable in your company? Well, Figgie spent a lifetime purging companies of unnecessary expense and improving bottom-line profit. He says that a 10% across-the-board expense reduction is almost always attainable. In the case of PDQ, that’s $350,000 per year added to the bottom line, boosting profit to $532K per year or 14% of revenue. Figgie says that often 20% to 30% expense reduction is achievable.