“We have a flat economy that’s really hard to measure.”
In episode #89 of Mission to Grow, the Asure podcast that serves as small business owners’ guide to cash, compliance and the War for Talent, speaker, entrepreneur, and financial expert Greg Crabtree, Partner at Carr, Riggs & Ingram joins host Mike Vannoy to share labor efficiency, scalability, and the significance of profit in fueling sustainable growth. Greg also focuses on practical and strategic financial advice for small business owners aiming to succeed in a competitive and evolving economy.
- Businesses seeking efficiency should analyze their models to eliminate unnecessary components, such as having accounts receivable without inventory or vice versa, as this tends to correlate with higher profitability potential.
- Prioritizing the establishment of a fully capitalized business is crucial for fostering positive cash flow growth, with subsequent returns on investment becoming feasible once this foundation is solidified.
- Employing a profitability strategy centered around the gross margin to labor cost ratio is imperative for businesses to uphold a robust balance sheet, serving as a fundamental aspect of financial health.
- In a fast-paced, competitive market, businesses need to stand out by prioritizing active selling techniques. Engaging customers proactively, meeting evolving needs, and demonstrating adaptability through proactive sales strategies are vital for sustaining relevance and competitiveness.
- Businesses aspiring for growth may find it essential to restructure their models, which could involve simplification, scalability improvements, and adjustments aligned with evolving market dynamics to achieve their expansion objectives.
Explore our Payroll & HR solutions that boost back-office efficiency to enable your business to scale.
Read the Transcript:
Mike Vannoy:
Have a really, really cool guest today. He’s a speaker, he’s an entrepreneur. He is a financial expert. His firm has been named in the Inc 5,000 list. He’s presented in over 15 countries. He’s a frequent speaker to groups like eo, scaling Up Vistage and H Tech. He’s been a member of the Entrepreneur’s Organization for almost nine years. He’s the author of two books, simple Numbers, straight Talk, big Profits, great book, highly recommend. I’m not through number two yet. Simple Numbers 2.0 rules for Smart Scaling. He’s the partner at Carr’s. Gram is the top 25 accounting and advisory firm. Welcome to the show, Greg Crabtree.
Mike Vannoy:
Appreciate it. Thanks for having me, mark.
Mike Vannoy:
So Greg, man, lots to talk about for small business owners trying to grow their business, if you just had to give one single piece of advice to small business owners, what would that be? To help them grow their business through a financial lens.
Mike Vannoy:
Right now, what I would tell them is they have to assess a tectonic change in the marketplace As we were chatting pre-show. And that the last 20 years was what I call the participation trophy economy. It was growing. We patted ourselves on the back of how effective our marketing and sales techniques were, and we were just being given gifts of the market and we were getting our share of the market growth, but we weren’t gaining market share. Population demographics is tilted all of my peers. I’m the tail end of the baby boom generation. We sailed off into sunset here the last couple of years and there’s not a workforce that’s large enough to replace us. And part of it too is you got to understand the most valuable years of your career, the last 10 that you work. And so the last 10 years has been the swan song of the baby members. And so now they’ve taken that wealth, they’ve gone off market. Now there’s still a residual consumption from that group, but they will start shrinking their consumption as they get older. And with a declining birth rate in the US that’s probably pushing a 1.5. When you need a 2.1 to be stable, the workforce isn’t there. AI is going to help a little bit, but AI doesn’t know how to dig a ditch. I mean, ai, there’s things that can’t do.
And most of my experience so far, AI is not replacing jobs, it’s just augmenting better capability of the jobs that already exist. But there’ll be a few, no doubt. But at the end of the day, what I say that we’re into now is we have a flat economy in real terms that’s really, really hard to measure. I’ll give the government some slack of gross domestic product is a really hard thing to measure because that’s an output measure. Well, how do you measure output in a labor centric economy? Well, and it’s ours. No, it’s not. I mean, I got news for you. I mean, one of the key premises of simple numbers in our philosophy is the isolation of labor. And our rule is never, ever, ever mix labor with something that’s not labor. I must isolate labor because it is the main fulcrum that you use to create leverage in a business. And
Mike Vannoy:
What do you mean by that, Greg? When you say you must isolate it, you’re saying from an expense
Mike Vannoy:
Perspective, from an expense perspective and from an analysis perspective, I mean, if you go read a public company’s financial statement, you will not see labor broken out in that financial statement for a reason. Part of it, they want to hide it, but two, they like to play games and move those things around. So in our simple numbers presentation, we will isolate direct labor and management labor. We can do some sub-analysis for bigger companies, but essentially for our smaller businesses that the 10 million and under businesses, we really highlight the idea, Hey, I don’t really care who’s directing his management. 90% of the businesses in the US work off of one economic standard to be profitable. I need $2 a gross margin for every dollar of labor I spend. And I don’t care what they do. I don’t care if it’s the CEO or the floor sweeper.
And almost every core business works off of that number. And you’ll see businesses you can survive at a 1.8, you are running hot at a 2.1. But one of the things in our practice that’s unique is, I mean we have clients all over the us, Canada, Australia, our US clients, we take a hundred of those clients and we use them as an economic model. We call it our simple numbers 100 model. It’s about a billion of revenue. So the average company is a little over 10 million a year in revenue, some bigger, some smaller, but the average is 10. And we use that as our economic picture of what the marketplace is actually doing because the government doesn’t have that data. I mean, the best estimate that I’ve seen is over 60% of the US GDP or by privately held businesses that do not publish their financial data. So how is it the government comes up with economic statistics? Well, it’s a wild ass gas. It’s
Mike Vannoy:
Just Greg, can you unpack this ratio a little bit for us?
Mike Vannoy:
Absolutely,
Mike Vannoy:
Yeah. How do you get there?
Mike Vannoy:
Yeah, so how you get there is you start with revenue, which is one of the weakest numbers known to mankind. It’s just a starting point for math, but do not fall in love with revenue. The next number is cost of goods sold. What are my materials or subcontractors, direct travel, those kind of things. I’m going to take those things that are paid to somebody outside the business that’s part of what I’m billing my customer for. Take that out. And that gets me to gross margin. Gross margin is before any labor cost have been deducted. Gross margin I content is the true economic top line of every business. And so you’ll notice if you turn to page 22 of this simple number straight talk big profits book, my first book, you’ll see it was kind of this first aha moment. And if I took a $20 million construction company and compared it to a $3.7 million services business, and once I subtract cost of goods sold and get the gross margin, they’re both a $2,850,000 gross margin business, 20 million in revenue.
And it’s like, well, big whoopty do. You’re a construction contractor with a pickup truck. I mean, come on. But if you filter everybody down to gross margin and then run your ratios from there as if that’s the top line I can compare, we put everybody on a level playing field when we do that now. And then, as I said, the number one profitability metric is how much gross margin I get for every dollar of labor. Now in the world of labor, there’s different plays you can run. Just like in football, am I a running team? Am I passing team? Am I a balanced team? Labor strategy is the same thing. And so therefore, the reason why I start with that total LER metric is LER stands for labor efficiency ratio. We’re looking at a dollar of labor as an input, what is the margin output? Whereas for centuries, accountants have flipped that formula and looked at labor as a percentage of something typically revenue, which is a grossly flawed calculation.
Mike Vannoy:
Right. I want to go deep on the labor efficiency. Where do you see firms making mistake on even how to get to gross margin? Because what you just described is purely outside expense. I know there’s a lot of small businesses I’ve done it with. Maybe you’re going to teach. The mistake I’ve made is, okay, the labor associated with directly serving that customer or delivering on that goods or services, I’ve thrown a lot into cogs. Where do you see people making mistakes?
Mike Vannoy:
Well, the mistake is you’re mixing labor with something that’s not labor. So there’s three data points in what we call the business engine. So I start revenue minus cost of goods. That’s not labor. So that gets me to gross margin. Gross margin minus direct labor is what we call contribution margin. It’s essentially gross profit. If you do your books in QuickBooks, QuickBooks will force that label of gross profit. Gross profit’s a sloppy term. So we stick to any sub component of your economic model. We like the term margin. So is it channel margin, is it gross margin? Is it contribution margin? Those type of things. But when we get down to that number, that’s telling me what’s the true output of the business engine? And that’s the piece that is going to scale what you’re a viable business. More than likely that part of your business is going to stay at those same rates unless you start to perform badly.
And I refer to this as the law of the big. I mean as you get bigger, you actually get worse in your metrics. You don’t get better and you have to fight like the dickens to hold onto your margin. Hold on to your labor efficiency ratio because as you get bigger, you hire more people. And I mean you have an HR background and you understand this completely. When I go from 50 employees to a hundred, I got a lot more people that are sitting around figuring out what to do and they’re not as productive individually as they were when we were 10 people and we were focused on production’s. A lot of
Mike Vannoy:
Make our world that’s even harder yet because there are literally more laws you must comply with. It’s not just revenue going up into the right, it’s number of laws I must comply with number of tax jurisdictions and the level of complexity goes up. So it’s an easy trap to fall in to just simply throw more labor at solving those problems.
Mike Vannoy:
And granted, there’s a handful, I mean a really, really small group of outliers on the upside, A handful of business models on the downside of that too, gross mark, $2 a gross margin to every dollar of labor model. Typically the companies that are going to be below the two that can survive, those are what we call staffing companies. So essentially you’re hiring a person who goes and works for somebody else that I don’t manage. I don’t have management costs for that. So that’s how you somewhat get away with it. But staffing leverage model is pretty dreadful for the most part. So really at the end of the day, once you know that target, that $2 to $1 of all labor, that’s an immediate health diagnostic. If you’re a consistent business without seasonality, I can take the last three months of your data and do an immediate health diagnostic of your business and say, well, here’s your problem.
Mike Vannoy:
HR, I live in a world of, we think a lot about FTE versus part-timers because there’s different legal requirements.
Mike Vannoy:
You count bodies and you’re counting pieces of bodies and that is the
Mike Vannoy:
Flaw. And in that we, not my firm, we, I’ll say the HR laws, the IRS, it simply requires you, there are formulas you must follow by law to calculate FTE to calculate part-time because it affects whether you have to provide benefits, et cetera, et cetera.
Mike Vannoy:
See, those are compliance issues. Those are not productivity issues. Yes, they’re important, they’re important for compliance management. But at the end of the day, a dollar is no respecter a person’s. It’s for every dollar of labor input. What is the lever of margin output that I get? Now sometimes if you’re in a professional services world, so I can actually get to labor efficiency by person of my direct bill people because the way our timekeeping system works and allocation of write-offs and those things, I know a reasonable approximation of revenue by person and we don’t have a cogs for what we do. But if we did, we could calculate that. Now the thing is, I got people that don’t produce, they support the people that produce. So if I’m going to get a two total LER of gross margin to all labor, I got to have my direct people getting more than a two lever to get there to cover the cost of the people who don’t produce.
They support the people that produce in that process. Now, other businesses that are team oriented, sometimes the first client, we refer to ’em as client zero. The first client that we started doing a lot of this labor efficiency analysis on was a landscaping company out in Omaha, Nebraska. And so we were looking at the total number, but then we started breaking it down by types of work that they did. So they did landscaping, they did irrigation work, they did snow removal and they did lawn mowing. Well, snow removal is kind of an off season thing. So we take, and it did have a labor efficiency ratio, but take that one out of the equation, not a 12 month a year thing, but all the other things they did roughly 12 months out of the year, a little bit less mowing in the winter obviously, but still some.
And so we looked at it and we looked at we could measure gross margin by those three types of services and we can measure labor by those three types of services. Well, they got a four to one ratio of direct labor to gross margin and landscaping and irrigation when they got $2 and 50 cents leverage on mowing. And so we were sharing the data with the team members at the company and the $10 an hour mowing guy, this was back in 2009, so that’s when you could pay somebody $10 an hour and mow grass. The $10 an hour mowing guy uttered these words of wisdom looks like to me we shouldn’t be in the mowing business. And it is like that is a perfect example of simple numbers. Now, if I share this and I’m going to crack on my accounting brethren, if I share this with a group of accountants or financial hootie totie types, they’re just going to go all into a TI and start arguing. And it’s like you don’t understand the simplicity of this. The guy’s, right? And that company today does not do mowing. They subcontract it out, they get a cut as a marketing fee for having sold it. They don’t have to do it.
And it’s that simplistic understanding of what are the DNA building blocks of labor leverage that there is not a business that exists in the world that does not leverage labor to create profit.
Mike Vannoy:
Greg, I’m assuming you have business owners all the time say, oh, but you don’t understand my industry. Yeah, I want a hair salon. We’re a hundred percent commission, or we’re a hair salon and I pay salary or we’re a hair salon and I pay an hourly plus bonus. I mean, everybody’s got their models.
Mike Vannoy:
That’s right, they do.
Mike Vannoy:
How do you help business owners compare and contrast different ways to approach the problem?
Mike Vannoy:
Well, I mean the symbol numbers, structure is what I mean, I guess I kind of fell into it, but I mean it’s magical from that standpoint because let’s take, the hair salon is a great example. I have two different ways to run a hair salon. I can hire employees that do styling and so therefore there’s a revenue number that I charge the customer for. There’s a cost of goods for supplies and chemicals and those things in the hair styling process that gets me to gross margin. And I guarantee you guys, a hair salon works off of the two to one standard. I can spend $1 of labor for every $2 a gross margin that I generate. Some of that goes to the stylist, some of it goes to the front desk staff that’s checking people out, scheduling, doing bookkeeping, and the overall general manager of the business.
So that business model of the hair salon is just like an NFL franchise. There’s a salary cap and guess what? Your salary cap is gross margin. And I get to take 50% of that gross margin and use it for labor. And I can then decide do I want a steady run of low paid s stylists that will over and go leave and go someplace else for more pay? Or do I pay them a little bit more to keep ’em stable? But if I pay them more, I have to be more efficient with my management labor. I can go heavy, direct skinny management, I can go skinny direct, I can go heavy management, take your pick. I can win both ways, but each comes with the counterbalancing effect that I have to balance for. I can’t go heavy, heavy otherwise I have a job with all the headaches of ownership and I make no money.
Mike Vannoy:
And so the magic, it’s just, it’s as long as you’re living within your two to one ratio, those are the decisions you make, right? Right. Oh, I’m going to provide benefits and I’m going to have all this Cadillac services for my stylists. Maybe that helps you to recruit the most talented people and retain them. That means you’re going to have to have an operating strategy that is really, really lean.
Mike Vannoy:
That’s, or
Mike Vannoy:
I’m only going to hire fresh graduates from cosmetology school and it’s not going to cost me as much money, but I’m going to have to spend a ton in training in development and recruiting
Mike Vannoy:
Now. So let’s go the other model. See, the other model is the booth rental model. So I have revenue, I charge the customer. My cost of goods sold is now the cut that I give the stylist. I don’t get that that goes to them. And now I got a much lower gross margin. I probably may allocate some of my labor to direct or not, but it’s still a two to one ratio. And so if I’m doing booth rental, I can only spend $1 of labor for every dollar of gross margin that my stylist after their booth rental. It allows me to do, and this is just a universal concept with very few outliers, but once again, every business has its perfect signature and you will live to that signature unless you dramatically change your business model. But for example, our a hundred company model of that billion of revenue, we now have it the most recent split. We split it between the companies that are up year over year versus down year over year. So just to give you a clue of the current economy, 70% of that billion is up year over year in revenue and they’re up about 10% year over year. I can’t tell you exactly, but my sense is about 8% of that 10 are price increases, not productivity increases and not output increases. The 30% that’s down, they’re down 17%.
Now if I take the group that’s up, that’s up year over year. Their total labor efficiency ratio to the group that’s down 1.69, they’re sucking on profitability. And the one reason why they suck on profitability, they have adjusted their direct labor as they have fallen 17% in volume. They didn’t adjust their management labor. They’ve held on the management labor saying, oh, this is temporary. Oh, we’re going to go back up. I got news for you. No, you’re not going to go back up because that 30% that’s down, those are the discretionary businesses that they got to fight for their place in the customer’s wallet. And there’s a lot of competition for customer
Mike Vannoy:
Wallet right now. That’s like the perfect segue to come back to the top where you’re talking about we are not living in the same world we were five years ago. I talk about this all the time that I think people falsely blame a pandemic. Obviously that was a huge thing that impacted all of us, but a pandemic presidential politics, the war Ukraine, inflation, we blame all these things, but the biggest driver for us is demographics and birth rates
Mike Vannoy:
Of it’s birth rate. It’s
Mike Vannoy:
Absolutely years ago in the supply of labor and the amount that people consume at certain ages, so young people, they’re reliant on their parents. They might spend a lot, but it’s not their money. You start getting out of school, you start to have a family. Your car’s more expensive, your homes are more expensive. You start having babies, they get real darn expensive. You become an empty nester, you maybe still paid a mortgage, but it’s based on 10, 15, 20 year ago prices and your car may be paid for, you don’t have as many crumb crushers that you’re feeding. So the consumption goes down. It’s like it’s both supply and labor and consumption that I’m an old Xer, you’re a young boomer. It’s like what’s this era kind of comes through. We are truly in a new world and it has nothing to do with pandemic politics.
Mike Vannoy:
Now the pandemic was just a distraction actually. So we were tracking this data before the pandemic. And so our hunter company model showed us, I started in my base year was 2013. And so this is my growth because we really didn’t have much in the way of inflation throughout the late teens. I mean it was two 3% a year, but I mean we couldn’t get clients to raise prices. They were profitable and they were doing good and they were competitive and they were happy. And so in 2014, our model had 14% year over year growth. Sorry, 14, it was 20% year over year growth. 15 was 14% year over year growth, 16 was 15% year over year growth. 17 and 18 were 22% year year growth, but 19 was eight. And if you go back, and this is where people lose context of history and movement of data, we ran out of labor in the middle of 2019 and that’s when you started to see key team members being poached for higher pay. You couldn’t, we’d already dropped below. We were about 4% unemployment at that point. And the rule of thumb has always kind of been if you drop below 5% unemployment, you’re down to the unemployable anyway. But now, I mean we’re down in functionally in a lot of the markets it’s one or 2% unemployment
Mike Vannoy:
For me, people don’t know when you think, what’s the biggest thing that happened in 2020? Obviously pandemic comes to mind. Presidential politics was a bit of a hot mess, but I think over the long span, 2020 was the tipping point where there were more people over working age 65 than there were under working age of 21. It’s the first time in our entire country’s history and it got missed because of all the other big stuff that was happening ahead. And
Mike Vannoy:
You did the one thing I will say the pandemic accelerated the people on the edge of retirement to just go ahead and retire. Now, a couple of those, some of those have come back and started to work a little bit, but it’s still just not enough to matter. But even in my own case, I mean, I did my part, I got four kids, but I’ve only got five grandkids and I got five granddaughters. And I keep saying, Hey, I said, listen guys, until you get to nine, I need nine grandkids to maintain 2.1 replacement birth rate. That’s right. But think they’re not going to listen to me. But at the end of the day, it is what it is. And I mean the demographics is kind of like icebergs in the ocean. I mean, you kind of see the top of it and you see it, but you don’t really recognize the impact of it because the mass of it is below the surface and out of sight, and it’s so connected to so many moving things. But here’s the thing, is that so bad? So let me throw this out. Yeah.
Mike Vannoy:
So let’s tie this back to so you and I geeked out on demographics or destiny and all this kind of stuff. Why does it matter to the small business owner? What does this new economy look like?
Mike Vannoy:
Right. So the thing is everybody’s employed. I mean, I would challenge most people to say, do you actually know somebody who literally cannot find a job to feed their family? Now they may be unemployed waiting for the right job. I’m not talking about that. I’m saying, can you go make some money to put food on the table? And in almost every market, all across the us, unless you have some lack of capability, everybody’s employed. Now, when the marketplace is employed, that’s a good thing because we have a stable consumer base. The bad thing is it continues to be, I think the Fed has undersold the idea of labor inflation is still the main cause. And we see this, and I’ll give you a great example. We have HVAC group that we track that’s a hundred million of revenue of about 12 companies, and their revenues are up 45% cumulative over the last three years.
Their labor is up 45% over the last three years. Their operating costs are up 45% over the last three years. I mean, this is a classic business that because they’re unnecessary, they’re able to pass through the price increases that they get from everything in their value chain of that. But the main driver being labor because there’s not an excess availability of HVAC qualified technicians and not going to be right. And so they’re able to price that in. But this is where the upstairs downstairs economy comes in and your listeners have to decide, are you a necessary where you can adjust your prices to your cost? Are you a discretionary where you got to climb, you got to get to the upper end of the discretionary food chain of where you’re a highly desired discretionary, not a I can live without discretionary.
Mike Vannoy:
Yeah, yeah. I love that.
Mike Vannoy:
Love that. And that’s where, like I said, we’re an upstairs, downstairs, 70% of the market are primarily necessary. 30% of the market is the discretionary. And you could even argue some of that. 70% is really discretionary if you really got hard with it. But everybody’s employed. You don’t have to get hard with it when everybody’s employed. I mean, every recession that I’ve lived through in my lifetime came with a minimum of 7% unemployment to as much as 11 to 12% unemployment and as much as 15 to 20% unemployment in certain key areas of either demographics or hyper-focused location in certain blighted areas. I mean, I can’t find it anywhere in the US right now.
Mike Vannoy:
I’ve been writing articles on this for maybe a year, year and a half now. And I’m not an economist.
Mike Vannoy:
I’m a chicken farmer by trade. So what do I know?
Mike Vannoy:
I’m a farmer. My wife’s a rancher and find ourselves in corporate America. Every recession is always tied to unemployment. Well, unemployment’s at what, 3.7%? This is the first time since the Nixon administration, we’ve gone two years under 4%. And when you see the demographic change, when you realize it’s because of the demographic change, not because of other economic drivers, there’s not going to be an accompanying high unemployment rate. Therefore, is there going to be a recession? I think what we’re in is this massive, painful reset of expenses of labor versus goods.
Mike Vannoy:
Well, and the way I’ve kind of described this is, listen, we got to forget about painting the economy with one broad stroke. There are some people that are living a recession. There are some people that are living an adaptive growth to the market. I will tell you, I don’t have any clients that are massively growing in real output. I just have clients that are able to pass through their price increases.
Mike Vannoy:
That’s really well said. Interesting. That’s interesting.
Mike Vannoy:
And I get it. I’ll give them some slack. That’s a hard number to measure. When we were at an economy of things back in the sixties, you can measure industrial output by crates of shipment and those things. I got maybe 20% of my clients who can measure actual output. But the rest of it, it’s a fuzzy number.
Mike Vannoy:
Greg, you said something made me laugh when we were talking before the show that we went from an economy where all ships rise with a tide of demographics to now it’s the street fighter, the knife fight economy.
Mike Vannoy:
It is the street fight economy. And so like I said, you, you’ve got to be prepared. I mean, the last 20 years was the participation trophy economy, and we all patted ourselves on the back and thought we made this happen. And no, you didn’t. I mean, our clients are going through their marketing spin with a fine tooth thumb right now realizing that what they thought marketing did and helped them with it, it was work that was going to show up anyway. And I’m a big fan. I’m not cracking on marketing because I am a big fan of effective marketing spend. It’s just difficult to find what is effective. And we’re constantly scanning the landscape of our clients who are truly successful in that vein of doing it. But those are things that people are having to readjust to. But now it is a question of fighting for your share of the market.
And one of the things I get to do in my entrepreneurial organization experience, I get to chair executive ed program at Horton Business School and I get to present one of the days of content with the other legitimate professors. And here they let this chicken farmer show up and say a few things. But the lead professor, David Wessels, I mean he is one shark dude, the first year that I sat through that class, he made a statement that just always stuck with me. Sometimes you have to change your where not your share. And I think if you want, let’s get back to the first question of how do you grow? You may have to grow by changing your, where you’re a fixed geographic location that’s pulling your customers from one area, but to fight for market share growth, just think of Coke and Pepsi. I mean the billions of dollars that they spend fighting each other for that 1% movement of share of the market. I mean, it’s brutal. And so, okay, well, let’s maybe think about, and what they’ve both done is gone global and gone into markets where they would be 80% of the market of something where they didn’t have to fight until the other one came in and started beating ’em back. But I think a lot of the smaller businesses have to start looking at that is my share growth strategy is totally different than getting my share of growth strategy. And that’s a change in mindset.
Mike Vannoy:
I’ve given counsel to businesses that you got to get away from geography based value props and more into it could be you’ve got a supply chain uniqueness. You could be a vertical based uniqueness. How do you help a small business owner get there when they see themselves? We’re the best X, y, Z provider in this county or this tri-state area or this state. How do you get to that next level?
Mike Vannoy:
Well, I mean just kind of in our simple numbers process, we say, listen, I need to tell you where you’ve been. I need to tell you where you’re at and I need to then help you look and project where you’re going. And part of that is you’re going to take a first cut at the business of looking at it. So think of it as splitting it into two pieces. What is your engine performance and what is your chassis that you’re using to support that engine? And most of the times the companies that need to be fixed, and our philosophy is really simple, get profitable with what you’ve got before you think about growing. So if you are not presently hitting your minimum profitability standards, why do you think growing’s going to make it better? No, it’s only going to get worse. So if you’re past startup stage, you got to get profit of what you got so that then you’ve got the pattern to scale. And then once you get that pattern of what works, you’re going to look at the engine, the three numbers of revenue, cogs, direct labor, get to what is my contribution margin for the engine. Now, once you start to become a bigger business, guess what your engine has really multiple engines. I do four things. My business is we do three things. We do consulting, we do tax returns and tax advisory, and we do outsource bookkeeping. And so I have an economic model for all three.
Each of them has a different profitability lever ratio between the revenue that it generates and the cost of the labor that it takes to produce it. Bookkeeping is arguably more of a commodity type service. And so what we want to do is rise to the non-commodity sector of the bookkeeping services and not try to be the answer to the masses. We want to be the answer to the specific higher margin areas, taxes. Its own unique beast with the challenges of dealing with a totally dysfunctional IRS for the most part. And it’s got its own labor challenge because the kids coming out of college today look at doing tax returns like it’s working in the New York City sewers. So that has its attraction challenges. But I think part of the labor market is coming back to it and realizing it is pretty steady work. And I think we have a unique approach to it that if we can work it the right way, we can take the season.
This is kind of my innovation is I want to take the season out of that work so that it is a pretty steady workload and there’s a way to do it to where even though you have some collision around deadlines, you can work it. So those are strategies, but you got to understand the profitability model. And then our unique offering is our simple number of consulting because it is our own take that’s based on what’s in the content in both books. But we see business through a singular lens that has proven pretty powerful. I mean, to be quite honest, I mean it’s one of those things that I think these learnings have been hiding in plain sight for a long time. And the things that I glean, I didn’t learn it in school, I learned it from my successful clients and I learned it from my unsuccessful clients.
I always like to say, when all of us fails, you can always serve as the bad example. So we’ve learned from a few of the bad examples too, but it’s like this labor efficiency thing has just been sitting there and I was talking to one of my partners this morning and I need to do this. And we have a few clients that we can go do this as a study. Here’s my contention. So I’ve just told you the magic numbers too. So if anybody leaves this podcast, just remember the number two, I need $2 a gross margin for every dollar of labor. I don’t care what that labor does, that’s kind of the standard you want you to go look at and everybody can do that calculation or should be able to do it. 20 years ago, did we look at businesses? What do you think the total labor efficiency ratio was 20 years ago?
Probably changed, right? It’s two, what was it 40 years ago? Two, because here’s the thing, you may get a moment up to 2.1, maybe even to 2.2. And then as competitors, you can’t hide forever as competitors figure out what you’re doing and they compete with you guess. What do competitors do when they try to compete you? Well, they offer a lower price for the same thing, and it competes the ratio standard back to the mean because the two is the standard of what it takes to meet the median profit standard, not the minimum profit, the median profit standard. And so there’ll always be some below and some above, but the average is going to be two. And so the market always gives away its gains. And so this is my argument to the AI Dreamers of the world. Yes, AI is going to help increase some productivity in certain areas eventually, but people will give away that benefit eventually as they compete against each other and compete you back to, I need $2 a gross margin for every dollar of direct labor just the way it is.
Mike Vannoy:
Yeah, I’m a huge believer in the promise. I think the timeline is probably in question, but the promise of ai. But you’re exactly right. Oh
Mike Vannoy:
Yeah,
Mike Vannoy:
The productivity of my own team. We’ve been early adopters on ai and our productivity is just, it’s crazy as we use it, but it’s just a matter of time before everybody else is using it. And then all sudden you’re back being
Mike Vannoy:
Equal. That’s right. That’s right. And it allows us to do more, which is great. I mean, we need to be able to do more with less labor. But here’s the other competing force. Everybody would agree with this. Very few I think would disagree with this statement. We are consistently paying more and more for our labor every day and getting less and less for it. Now. That is what the pandemic accelerated. Now, that trend was already happening a little bit before the pandemic, but the pandemic accelerated. Say
Mike Vannoy:
What you mean by that. I would’ve thought maybe the opposite labor becomes more productive through advanced tools.
Mike Vannoy:
No, I mean it might a little bit, but really at the end of the day, people are working work, they want to make more money because the marketplace is competing for that labor. Just like look at NFL salaries. I mean, what were NF salary NFL salaries 20 years ago? And then what are they today? I mean it’s massive. Well, the average
Mike Vannoy:
Scale, I’m still stuck in my FTE mindset, right? Because thinking how productive is this FTE versus how productive is the dollar spent,
Mike Vannoy:
Right? I used to pay $40,000 for an entry level bookkeeper and now it’s 60 and that person is producing less, is less prepared, is working less hours for that same dollar amount of pay is what they were. Now part of this is, and I do agree, companies that paid people’s salaries and worked people time, they cheated the market. I mean, that’s really a labor productivity cheat. And my profession is king of the cheats in that process. And I wholeheartedly disagree with that idea. And I think you’ve got to be fair with labor practices. And now labor has a way to effectively negotiate because it’s scarce.
Mike Vannoy:
That’s exactly right.
Mike Vannoy:
And so therefore we’re seeing a more balanced labor marketplace of pay me a fair salary. And so what I always tell my clients, I say, listen, pay a fair market wage because it then gives you the moral high ground to demand fair market performance. And if we have equilibrium of those two things, I’ll win every time.
Mike Vannoy:
Greg, one of the things you talk about in your book is the challenge employers sometimes have, they’ll, okay, maybe my strategy, and I’m going back to that hair salon example, I might have a high expense strategy. I want to recruit the best, I want the most talented people. They’re going to impress the clients the most, but therefore I got to have a really thin management structure. What’s the trap about simply paying more to simply so paying top of market and what does that really get you? I think you talked about your experience that doesn’t,
Mike Vannoy:
Well, as long as I get top of market margin out of it and if it’s a pure service, top margin of revenue. But again, there’s a graph that I put in the second book in the LER chapter and it’s one of my probably most requested graphs. It’s called the career labor efficiency curve. And so think of it like this of a producer that’s an employee. There’s three phases. There’s the training zone, the chasing zone, and the replacement zone. And so the training zone is I’m paying a person more in compensation than what they’re producing because they’re training. And the goal there is I’m trying to compress that timeframe to a shorter period as possible to at least break even and then have that person enter the second phase, which I call the chasing zone for a reason. And the reason why I call it the chasing zone is if a business is to be successful, your pay must chase performance, not performance chase pay.
And companies that fail in their labor strategy, they overpay and they’re constantly having that expensive person chase a performance metric. And every time they get close to it, the person, oh, would I need a more, if I don’t get a raise, I’m going to go someplace else. And we see this in all of the professions industries, and yes, the person is producing something, but when you quantify it, I mean I can stack rank every person in my office of here’s your revenue you produced, here’s what I paid you. Here’s your individual labor efficiency ratio. And I can stack them from the best to worst in labor efficiency ratios. And when you start to get a person that’s below a two individual labor efficiency ratio, they are sucking that If I need a two overall, but I got a direct person that’s below a two, they’re detracting from the system. And we see this in practices of all types all over the place. And we go, why are you doing that? That person either needs to produce more or you need to bill more for when they do produce, pick one of the two, but the current economic relationship of revenue to what you’re paying them isn’t working.
Mike Vannoy:
Greg. Some jobs are easy to quantify A sales job, maybe if you’re a direct billable type,
Mike Vannoy:
Direct billables,
Mike Vannoy:
Lots of jobs are going to be hard. They’re somewhere in the value supply chain that’s hard to quantify. How do you help firms? How do you help someone?
Mike Vannoy:
Well, you look at those as teams, and so like my manufacturing clients, I mean, I look at gross margin to the direct labor of the team on the floor that’s producing stuff, and we’re monitoring that number. And the thing is, is we monitor our primary labor efficiency metric would be looking at it on a rolling 12 basis. Secondary would be rolling three. So I’m looking at rolling 12, I believe the most. That’s all 12 months, all four seasons. Every dog ate my homework. Excuse rolling threes. I have to be mindful if they’re a seasonal business, but if they’re not seasonal, so a good example, we do a lot of work in the IT MSP space. And so our IT companies that do managed services, they they’re consistent 12 months out of the year. And so when we see one that’s failing in performance and we get them to fix things, we can see that immediate performance.
And I’ll give you a great example is let’s use a marketing firm. So I’d use this a lot of times when I do a talk, I’ll be talking to a group of marketing companies and they’re not profitable. I says, okay, here’s the deal. So we’re in the middle of February. I want you to look at March. How much are you going to pay in labor for the month of March? You know that today you can get within a rounding error of how much you’re going to pay in labor in March. Guess what your gross margin target for the month of March is two times labor. I guarantee you the rest of the stuff will work. You’re majoring on the minor when you’re chasing all these other operating expenses. You can’t cut kitchen supplies enough to get profitable
When you get the labor leverage. I rarely have to chase down any other operating expense. Occasionally somebody might be overspending on marketing, but I would say I probably have more times I’m gigging a client that’s underspending on marketing more so than overspend. So I would say it goes both ways. You mentioned this earlier, and I’ll tell you kind of an interesting trend that I see you mentioned about benefits. We just don’t have a lot of discussion with our clients about benefits anymore. I mean everybody likes ’em, but most employees are really pushing for, Hey, I need more spendable dollars in my pocket to deal with the current economy.
And part of it is the healthcare issue rightly or wrongly, kind of pushed that more common in the market that most businesses have an insurance strategy of how they deal with it. Payroll taxes are payroll taxes. I mean you can’t do anything about that. And workman’s comp is workman’s comp. But at the end of the day, I mean people aren’t pushing for 4 0 1 Ks and those things as much as when you give the vast majority of an option of you want me to contribute to a 401k or you want me to pay you more money, they take more money, they want the now. And that seems to now in some of the professional industries, I mean you got to look at your industry and say, what are the competitive benefits? But again, if you’re competitive in your benefits, you’re still back to that two to one gross margin to all over ratio. That’s the piece that makes everything else work. I wish it was more complex, I could charge more for it, but it’s not.
Mike Vannoy:
Do you see, I think I know the answer, but I think I would’ve been predicted. Wrong businesses, small businesses under 10 million, they’re trying to grow. You’re trying to get to the next level. Where is their model broken most frequently? They got too much fixed cost. They signed up for a big expensive lease in a beautiful place, or they got some machinery that they thought they’re going to use. Maybe it’s not as productive as they thought. Or is it those things are harder to fix, right? Because you’ve got long-term cost structures, but are they typically broken in the fixed cost areas or is it really as simple as labor
Mike Vannoy:
Efficiency? Rarely do I see a facilities issue. I mean rarely, almost never. It is a labor productivity issue. First of you used to be profitable and you’ve now descended into, I’ve paid people more and more money and I’m not charging any. I can’t get any more for it. And so you look at the medical industry that takes insurance, I mean brutal because they can’t change their price. They’re capped, but their costs have absolutely increased and you’re seeing them turn out expensive people that they would love to have kept, they just can’t afford ’em. And so they kind of change over others that our IT industry. A good example, they’ve let a lot of the senior IT people go, that got up into the 150, $200,000 super senior technician range going, it’s great to have you, but I can’t make any money on you. And so you have to let them go to a bigger company and be an in-house IT person or something like that.
But I can’t bill you for services when you get too expensive. And that goes into that third phase that I talked about, the replacement zone. So when you get to the third phase of your career, your salary keeps going up and up, but you kind of run out of juice at some point. Either or the market just won’t pay any more for your skillset. And when you see that compression of what your revenue is to your cost and it flips, you got to say, great knowing you, I need you to go find another job because I can’t make money off of it.
Mike Vannoy:
Safe to say that a lot of growth minded entrepreneurs think, okay, they think top line, top line, top line, I’m going to grow, grow, grow, grow, grow. And every dollar goes back on the business. I don’t care about profit and I’ll worry about making profit later. Right now it’s all about scale. They think it’s a scale game. What do you say those folks?
Mike Vannoy:
Well, let’s see. The scale game is different because the other, if I can get them fixed in their profit model, then their second problem is how do I grow? Because we’ve lost the art of active selling. We’ve kind of gotten lured into the last 20 years of being passive marketers. And I get it. I mean, passive marketing is a valid component, but we have, because the marketplace was so strong in the last 10 years, even last 10 to 15 since oh eight, the oh eight recession, if you go oh nine to 2019, that 10 11 year period was the fastest, greatest economic growth in US history, in my opinion. And I mean it was real growth, but we lost the professional sales skillset in the industry. That’s required when you get into a street fight economy where I got to go punch my competitor in the mouth and take their customer away from them.
And we haven’t been in that mode. You win customers from a competitor, but you didn’t go take them away. You just answered the door because they failed at serving ’em. That’s not taking a customer away. That’s getting a gift to the market because the market has put pressure on people to continue to deliver quality service with restricted labor. And so you’re going to see more service failures that will people to ship their allegiance in that market. But especially you see this in B2B businesses that those are hard sales businesses and the sales talent is at its all time low, I think. And our clients that need professional sales talent are really struggling to get that skillset, but they still have to get profitable. What, you’ve got to run a stable business now.
Mike Vannoy:
And I’ll say it’s compounded by the fact that the solutions are way more complex than they used to. Me
Mike Vannoy:
Too. That’s right. Now you said something else about putting all my money back into the business. If you hit your profit target, there’s plenty, we call it the distribution model that once I get you fully capitalized, so I got to get to your correct profit target and I get you to have two months of cash that covers your operating expenses for two months. Everything other that you don’t get terms on, that’s your target amount of cash in the business have zero drawn on a line of credit. That is our definition of a fully capitalized business. So it’s unique to every business, but that is, it’s probably one of the best concepts we ever came up with. It gives people a specific guidance for their business. Once you’re there, almost universally, you take 40% out of profit for taxes, you leave 30% in for growth, and I can distribute 30% as a return on investment. I don’t need to leave everything in the business. I got enough cash to pay my taxes, and I got enough cash to further capitalize it. And in most of our businesses that we teach to how to grow cashflow free, they don’t even need to keep the 30% for capitalization. They can almost distribute 60% of their profit and then 40% goes out for taxes.
Mike Vannoy:
And I know I’m co-mingling terms, but to me is if I’m an entrepreneur and I am, that’s the real scale, right? It’s let’s not dilute ourselves into thinking, I’m just going to grow and I can save out some costs later because it’s a big fixed cost business and I got operating leverage, blah, blah, blah. Your scalability is based on your model.
Mike Vannoy:
Yeah,
Mike Vannoy:
It is. Is that model cookie cutter enough? If I think about restaurant franchises of the nineties, or I think about here in St. Louis, an enterprise rent a car of the early two thousands. It’s like when you go from one location to three to five to 500, it’s because you’ve got a model that’s cookie cover.
Mike Vannoy:
But I’ve got a multi-unit client that has opened 12 locations and their cash positive from day one, I mean literally the location is profitable at the second month. And what they did was beautiful because they didn’t try to own the real estate of every location that they set up. They just had somebody build a suit, they get a little minor capital loan to open the business that the business can easily pay back, but they’re cashflow positive on every new location that they open. So they have infinite growth capacity. They just have to find another market that they feel good about can they get the traffic count for that location. And that’s the smart way to do it.
And a lot of people mix. What is the value proposition? Is it in the real estate or is it in the operating model? The only companies that really struggle to grow cash positive is if you carry AR and inventory. I’ve got two working capital components that are generally very onerous and hard to finance completely, and it forces can’t. Those are the clients I have that struggle to get them off of the line of credit drug because they’ve got two hard numbers. And the idea is I would be searching for an innovative way to get rid of one or the other, or clients who have AR but not inventory or inventory, but not ar. We can generally get them to a point of stabilization to where every unit of incremental growth is cashflow positive. And so we call that there’s a formula in the 2.0 book called CPR Cash Power Ratio. And so you’re looking at what we call a term we define called trade capital. So it’s a modification of working capital that’s actually more correct than working capital is. And you look at your trade capital ratio relative to your profit ratio and you’re trying to balance those two that as long as my profit is above my trade capital ratio, I’m cashflow positive for growth.
Mike Vannoy:
I’m looking at the clock, Greg, I could talk this for a very long time. Super, super interesting. Very, very fresh, pragmatic approach to running and then growing small business. I’d love to have you back on. Yeah, I
Mike Vannoy:
Appreciate it.
Mike Vannoy:
In and of itself, I think we have a whole bunch of topics we could go deep on. I’m going to include links to your books so people can purchase ’em online. I highly recommend. I appreciate that. Anything you’d want to say in closing for people to understand?
Mike Vannoy:
Like I said, I think just to understand that it’s still the best, most valuable investment that you’ll ever own is a privately owned business. It has the highest rate of return when run correctly of any investment you’ll ever have. Don’t be afraid of the challenges of the market because there’s plenty of poor performers that you can outperform, but you’ve got to stick to the principles. And this is not an environment for the stupid mindsets that we had in the.com era and some of the craziness that even in the last few years when the m and a activity just got out of hand and people were throwing money everywhere because all of those things kind of come back to the norm and the market settles back to physics and finance is based on physics. If you don’t make a profit, you eventually going to have a problem.
Mike Vannoy:
Yeah, that’s right. That’s right. Greg, thanks so much for joining me.
Mike Vannoy:
I
Mike Vannoy:
Appreciate,
Mike Vannoy:
Alright, thanks. Appreciate it,
Mike Vannoy:
Mike. And to everybody else, thanks for joining today. If you got value today, I invite you to comment, share with a friend, subscribe to the show, whether it’s on YouTube or whatever, your podcast platform of choice is Greg. Thanks again for joining me. I can’t wait to talk to you again on some of these other
Mike Vannoy:
Topics. Yeah, good deal. Look forward to it.
Mike Vannoy:
And that does it for another episode of Mission to Grow. Until next time, everybody. Thanks.
Greg Crabtree:
That’s it for this episode of Mission to Grow. Thanks for joining us today. For show notes and more episodes, visit us@missiontogrow.com. If you found this content valuable, I invite you to share it with a friend and subscribe to the show if you really want to help. I’d love it if you left a five star review on Apple Podcasts, YouTube, or wherever you listen. Mission to Grow is sponsored by Assure. Assure helps more than 100,000 businesses get access to capital, stay compliant, and develop the talent they need to grow. To learn more about how Assure can help your business grow,
Mike Vannoy:
Visit
Greg Crabtree:
Assure software.com. Until next time.