Do You Understand Your Costs to Ensure Profitability?

Do You Understand Your Costs to Ensure Profitability?

During a recent call with a CEO, we discussed the company’s profitability and what measure they used to drive profit – basically Profit/X. It became apparent that they didn’t have a handle on their costs and what they should be charging to ensure they hit their profit targets. I have addressed this a bit before to ensure that your margins were where you wanted and rejecting low-profit jobs. However, this time the issue is to understand the jobs’ profitability and price new jobs effectively.

The Costs

To determine profitability, we need to know our costs. Thus, we built a table listing every employee, the salary, additional expenses, e.g., health insurance, 401k, etc. (estimated at 35% of wages), and the amount of billable time. As a result, we had a table that looked like the one below.

Employee Costs

Calculate Hourly Costs

From this Table, we could determine the hourly cost of an employee. To calculate actual costs per hour, we took the number of billable hours, which for 2021 is 8,760, and subtracted 96 hours, the allowable PTO. However, most employees don’t work their total billable hours for various reasons, so we included a “slack” factor of 10%. For multiple reasons, most projects have “re-work” or errors that cannot be billed and estimated at 10% and included. As a result, the total “Billable Hours” was 7,800 rather than 8,760. These adjustments allowed us to produce the hourly cost for each employee.

Calculate Overall Costs

Taking that data, we then divided the hourly costs into billable and non-billable. We added fixed overhead, which was not related to billable expenses, e.g., CEO’s pay, office rent, etc. Thus, we now had a cost structure for the firm that looked as follows.

Billable Costs $1,099,150
Non-billable Costs 1,194,500
Overhead 750,000
Total Costs $3,043,650

Calculate Revenue

With the company’s cost structure defined, we could determine how much to markup hourly costs to make a 25% profit. Doing this analysis is easy in Excel; however, ensure you don’t make easy Excel mistakes. , and the result was that marking up hourly costs by 232% would enable the company to meet its profit goal. This analysis is shown below.

Revenue $4,056,895
Total Costs 3,043,650
Profit $1,013,245
Profit Margin 25%

 

Pricing of new projects

While I am a strong proponent of selling value, not time, if the company wants to know the minimum price to charge to realize its minimum profit, it can use this data. Identifying which employees will work on the project and for how long. For example, they would be able to cost it as follows:

Employee Hours Hourly Billable Rate Total Billable Charge
#3 25 $49.32 $1,233
#6 5 44.77 224
#10 20 43.83 857
#15 15 30.50 457
#17 10 48.67 487
Total     $3,258

With this data, we can now estimate jobs more effectively since we know the employees who will work on the jobs and how many hours they will commit. We have to build some waste into that model, but we have a good idea of how to price jobs.

 

Performance Table

Also, we can see either weekly, monthly, or quarterly how the company is performing. If we produce a table of the employees and clients and hours worked for a month, we can see the utilization of each employee and profit per client as follows.

Employee Utilization and Job Profitability

This table provides a good insight into the company’s and employees’ performance. As can be seen, Employees #3 and #6 are working more than their billable hours with utilization rates above 100%. While this may be good, one would need to ensure that whatever they were supposed to be doing with their non-billable time was being done. Also, Employee #9 is utilized 71.3% of the time, resulting in lost efficiency. Further analysis is required into why this is the case, but it identifies potential issues. Finally, it would appear that nearly half of the employees are working at less than 95% utilization. Given that the company’s utilization is already adjusted for “Slack” and “Rework,” analysis to understand why utilization is low is required.

We cannot only analyze employee performance, but we can see how we are doing with our various contracts. Clients #1 and #3 are losing money, while Client #4 is profitable. The data doesn’t tell us why, but again that would be work investigating as the company is performing below its goal of 25% profit.

Conclusion

As I stated at the beginning, concerning pricing, I strongly believe in pricing according to value and not hours; however, this analysis and methodology are helpful to understand what an organization’s minimum pricing should be and how it is performing. While several issues are highlighted and require more work, this provides a great way of knowing what to examine to improve performance.

If you would like to do this analysis, call me. I would be happy to help you.

Copyright © 2021, Marc A. Borrelli

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Sunk Costs Are Just That, Sunk!

Sunk Costs Are Just That, Sunk!

Working with my Vistage group this week, we had an exciting discussion about “If you were starting your business today, what would you do differently?” This discussion made me think of sunk costs and how they limit us. I have discussed how to make better decisions before, but sunk costs deal with our assumptions.

What are sunk costs? A sunk cost is a payment or investment that has already been made, and it is sunk because it is unrecoverable no matter what. So, it should not be a factor in any decisions from now on.

The Sunk Cost Fallacy

The sunk cost fallacy is when an action is continued because of past decisions (time, money, resources) rather than a rational choice of what will maximize the returns at this present time. The fallacy is that behavior is driven by an expenditure that is not recoupable regardless of future actions.

For example, a company that decides to build a new software platform. They have done their analyses and determined that the future benefit they will receive from the software will outweigh its development cost. They pay for the software and expect to save a specific cash flow level from the software’s production each year. But after a few years, the platform is underperforming, and cash flows are less than expected.

A decision has to be made: should the platform be abandoned or not? At this point, the software’s initial cost is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the platform compared to the value of replacing it today, not the original cost of the software.

However, businesses, organizations, and people often have difficulty abandoning strategies because of the time spent developing them, even if they aren’t the right choice for the company or individual. Therefore, recognizing what a sunk cost is will result in better decisions. 

How sunk costs sabotage us

Here are a few ways, but this list is not exhaustive.

At Work

Bad Pricing

Companies often justify pricing based on their costs. Most commonly, the R&D expenditure to develop the product. Whatever the R&D costs were, they are irrelevant to the pricing. The market will only pay what the product is worth, not what was invested in it. A pharmaceutical company’s attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars.

Similarly, many businesses price their services on the hours it took to deliver a service. However, the costs of providing the service are sunk, and you cannot recoup them. The market will only pay you what they deem the value of the product or service to be, so using pricing to recoup costs is “backward.” Instead, one should determine the price and then figure out how to deliver the product or service at the profit margin desired.

Consider if a company invested $100,000 to produce a product and planned to sell them at $100 each. However, the day after the product launch, a competitor announces a better competing product at $50. Will anyone pay $100 for an inferior product when the best one is available for $50?

Bad Investments

Sunk costs are why so many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile. How many times has an investor tell you, “As soon as X gets back to what I paid, I am selling.” Why?

What they paid is paid. The investor cannot change that; it is a sunk cost. The real question is, “Does X offer higher returns in the future than Y, some other asset I am considering, after transaction costs?” If yes, then stick with it. If no, switch out X for Y. 

Assume you spend $4,000 on a wine tour of Napa. Later on, you find a better wine tour to Bordeau that costs $2,500, and you purchase that trip as well. Later, you realize that the two dates clash and the tickets are non-refundable. Would you attend the $4,000 good wine trip or the $2,500 great wine trip? The $2,500 trip. The $4,000 trip is irrelevant in consideration because it is inferior, and the money is gone.

Bad processes

Returning to my initial question, “If you were starting your business again today, what would you do differently?” Many people will give outstanding examples of what they would do differently but never consider making the change because of the investment they have in their current process. As with assets, if your current process generates a cash flow of $X per year, and switching would generate some cash flow greater than $X after the costs of switching, you should switch.

Misaligned employees

Many companies have employees whom they know are subpar. However, they cannot fire them because they have been employed for a long time or the company has invested some amount in them. This situation is most often seen with those employees who have been with the organization since the beginning. However, the organization has outgrown them. 

Again, the time invested by the company and the employee are sunk costs. The decision is what is the best investment going forward. If a more significant return is achievable with a new employee, then the change is required.

Sunk Costs Exist in Our Personal Lives Too

Feel free not to ski in bad weather.

You may be considered a fair-weather skier, but the cost became sunk when you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive or you have a limited holiday window, but if not skiing in a freezing whiteout makes you happier, do it! Either way, you aren’t getting your money back.

Don’t go to the gym just because you have an annual membership.

While working out may be advantageous to your health, your annual membership shouldn’t dictate whether you go to the gym on any given day. If you have paid up front, then the money is gone. So if you would prefer to take a hike, ride a bike, relax and meditate, you should. However, I am not saying there may be more benefits to working out.

Don’t grow up to be a lawyer.

I chose lawyers because I was this example; however, I decided before I graduated law school that I didn’t want to be a lawyer. Assume you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can’t be worth starting over again with a new career? Unfortunately, time, energy, and money are all sunk costs, so if your end goal is your happiness, you might need to cut your losses and refocus your energies elsewhere. 

With the above examples, next time you face a decision, ignore all the sunk costs; you will make better decisions for your organization and yourself.

Copyright (c) 2021, Marc A. Borrelli

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Do You REALLY Know Your Business Model?

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What Are The “5 Parts of Every Business”?

Kaufman says in every business model there are “5 Parts of Every Business,” each of which flows into the next:

  1. Value Creation: A venture that doesn’t create value for others is a hobby.
  2. Marketing: A venture that doesn’t attract attention is a flop.
  3. Sales: A venture that doesn’t sell the value it creates is a non-profit.
  4. Value Delivery: A venture that doesn’t deliver what it promises is a scam.
  5. Finance: A venture that doesn’t bring in enough money to keep operating will inevitably close.

 

Value Creation

Kaufman defines Value Creation as “Discovering what people need or want, then creating it.”

Most customers don’t know what they need or want. As has been pointed out many times, people wanted a faster horse, not an automobile. However, whatever they want, in reality, they are just seeking a solution to a problem. Therefore, the critical issue is determining “What problem you are trying to solve?” Or, as Clayton Christensen said, “What is the job the customer is hiring you or your product to do?”

Defining this is often hard, as many companies don’t know what job their clients are seeking them or their products to provide. I have discussed this before. However, as the adage says, “people aren’t buying drills, they are buying holes.” This is a vital part of your business model.

So, working with your team to determine “the job to be done” and your “Core Customer” is well worth the effort because you can better describe what you do, and all your employees will better know what you do and how what they do impacts it.

 

Marketing

Kaufman’s definition is “Marketing is defined as attracting attention and building demand for what you have created.”

In today’s digital world, with Google, Facebook, Linked In, and Instagram, marketing separating yourself from the masses is hard, especially if people don’t understand the product and service. Therefore, by focusing on the job to be done or the problem you are solving, it easier to stand out among the crowd.

Also, as you identify what the “job to be done” is, you can better identify your Core Customer. Remember a Core Customer is:

  • An actual person with needs and wants. If you sell B2B your core customer is still a person because you have to convince a person to buy.
  • Who buys for the optimal profit.
  • Who pays on time, is loyal, and refers others.
  • Has a unique online identity and behavior; and
  • A customer who exists amongst your clients today.

Build Direct started as a company supplying contractors. However, it soon realized that while contractors were a key customer component, they were not the company’s Core Customer; instead, Build Direct’s core customers were young female DIYers interested in the products and education. Build Direct focused its marketing according to that recognition and started providing much educational content for young female DIYers. This specific marketing drove much better brand recognition and engagement.

Also, South Shore Furniture in Canada identified their core customer as “Sarah.” Sarah is so vital that there is a mannequin of Sarah in all meeting rooms, so no one forgets whom they are seeking to serve.

Besides, marketing to the correct demographic is easier and more fruitful if you know your Core Customer. Without this information, the marketing section of your business model is just hope, not a strategy!

 

Sales

Kaufman defines sales as “Turning prospective customers into paying customers.”

However, as Jeffrey Gitomer, put it “People don’t like to be sold, but they love to buy.” So the key is how do you move prospects into customers? Businesses have to earn their prospects’ trust and help them understand why it is worth paying for the offer. Another way of looking at this is, “What is your brand promise?”

Companies need to know what their brand promise is. For example, Starbucks is “Love your beverage or let us know and we will always make it right.” Some organizations may have supporting brand promises to prove more definition of the brand promise. Your brand promise must be measurable, because as Peter Drucker said, “What gets measured gets managed.” So if it is measurable and measured, the organization can ensure that it meets its brand promise, which provides more assurance to the prospect. Finally, with a clearly defined brand promise that is measurable, the organization ends up saying “No” more than “Yes” to opportunities and ideas since they will damage the brand promise.

Since no one wants to be taken advantage of, Sales is about educating the prospect to identify what is essential to convince them you can deliver on your promise. A clearly stated brand promise that is measured and quantified increases the ability to persuade the prospect to purchase from you. It amazes me how many business models don’t have a brand promise.

 

Value Delivery

Here Kaufman defines Value Delivery as “Giving your customers what you’ve promised and ensured that they’re satisfied.” With this, I have no issues. Anyone who doesn’t deliver what they promised is effectively a “scam artist.”

To ensure you that make the customer satisfied, you have to exceed the customers’ expectations. A popular way to determine customer satisfaction is through Net Promoter Score scores which we see more and more (if you are looking for help with NPS surveys of your customers, contact me). You want more promoters and detractors. However, the NPS score tells you what the customer thinks after experiencing the service or product. Companies need to develop systems that ensure the service or product is exceeding expectations.

A great example is the Ritz Carlton’s policy whereby any Ritz-Carlton employees can spend up to $2,000 per incident, not per year, to rescue a guest experience. This policy ensures that the customer is getting a great experience because it empowers employees to fix problems and provides the customers’ concerns are solved quickly. As David Marquet says, “Move the decision making to where the information is.” That is what Ritz is doing, and it is empowering employees and making customers happy.

Companies that have outsourced many functions to cut costs, so any customer has difficulty reaching the people they need or have to spend five minutes going through a phone tree to contact some is already failing at this.

Ensure your business model tracks customer satisfaction and you have ways to ensure that customers are happy.

 

Finance

Kaufman defines finance as “Bringing in enough money to keep going and make your effort worthwhile.”

As I have pointed out, this is key, and many people don’t realize the situation because of flawed analysis and lousy modeling. However, the key for any organization must be a well-defined “Profit/X.”

Many organizations don’t have a well-defined Profit/X, but there is a lack of discipline that ensures good financial performance without it. Profit/X is some unit of scale, and profit can be gross profit, net profit, EBTIDA, or EBIT. Examples that I have seen are:

  • profit per airplane
  • profit per job
  • profit per customer
  • gross margin per delivery
  • profit per employee

There is no correct Profit/X, just the one that works with your business. One organization that did deliveries chose Gross Margin/Delivery, which focused on reducing the cost of delivery to maximize profit. Once Profit/X is selected, the entire organization must seek to meet or exceed it; thus, everyone needs to understand it and how they drive it. With that focus and discipline, the organization is more likely to meet its financial goals and objectives.

 

Summary

In summary, the organization needs to be able to define its business model by the following:

  • Define the problem its products or services solve or, more precisely, what job they do.
  • Who their Core Customer is so they can market to them effectively?
  • What is their brand promise, and how is it measured?
  • That their customers are satisfied, returning and recommending.
  • That they have identified their Profit/X so that they are profitable.

Doing this work is an excellent exercise for any leadership team to help bring clarity to your organization. If you need assistance doing it, contact me. Good luck, and may your business grow.

 

 

Copyright (c) 2021, Marc A. Borrelli

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So how to solve this problem?

Working with some teams recently, I have come across the following system, which, while not perfect, helps get closer to what we want to achieve. For example, let’s say the topic is “Grow repeat business.”

 

100 Ideas, No Less

When starting the process with your team, the first rule is that we will not stop with ideation until we have at least 100 ideas on the board. Not only do we need 100 ideas, but no one is allowed to criticize, demean, promote, or challenge any idea until the 100 are there. This rule’s logic is to stop ideas from being shut down by some of the dominant participants. It is hard to get 100 ideas up on the board, and we progress through them, they get crazier, but that is sometimes where the gems lie. So, following our example, we could have the following ideas:

  • Create a membership club
  • Offer discounts to repeat customers.
  • Provide value behind a paywall for member customers
  • Offer bundling
  • Offer easy returns, e.g., Zappos.
  • Provide special shopping events for repeat customers or members
  • Offer suggestions to customers based on what they have purchased.
  • Free shipping for members
  • Special shopping days for members only
  • Early access to new products for members or repeat customers
  • Send you products that we believe you want and if you don’t return them then charge for them.

As can be seen from the above, many of these ideas are common, and we have seen them with Amazon and others. However, at one time, they were all new. Also, the last one, someone might think is “crazy,” but it doesn’t matter; it is still an idea to be put down.

 

Mind Map

Once you’re over 100 and there are no more ideas, time to organize. If there are still ideas at 100, don’t stop. I find organizing through Mind Mapping the best. For those of you who haven’t done Mind Mapping, take your ideas and organize them into “topics.” Elaborate on those by creating sub-topics and use short phrases or single words to identify them. Thus, once done, your 100+ ideas are organized into subtopics within topics, so it is easier to look at what each is seeking to achieve. In some cases, the ideas are just variations on prior ideas to be lumped into one. So, again looking at the ideas above, we could organize them as follows:

Membership Ease of Use Promotions
Create a club Offer easy returns Special shopping events
Provide additional value for members Offer bundling Discounts
Special shopping events for members Offer suggestions to customers based on prior purchases Special shopping days
Free shipping for members Free shipping for everyone  
Early access to new products for members   Early access to new products for prior customers
Send products and customer decides if they want them.    

 

10% AND ?

Once we have divided everything into our subtopics, then we go through them one by one. Each person has to identify at least 10 percent of what they like about any idea and then add to it. The next person builds on the last person’s statement, again identifying at least 10% they like and then adding to it. This ensures that nothing is shut down and that the creative exercise can take place. By having to build on something regardless of whether or not you agree, forces you to find the best in it and make it better – KAIZEN. The number of participants in the meeting will determine how many times you go around. As you go around, each iteration is recorded. This process further frees the imagination as you have to identify something you like about the statement before you and add something good. At the end of this process, some excellent ideas may have been arrived at. Then you can use a multiple voting system for the participants to identify what they like best.

 

So, Give it a try!

So, give it a try; you may find you get some fascinating and novel ideas from your group. Besides, as the group’s ideas flow, you should find a greater commitment to the ideas than those that the usual dominant people promote.

 

Copyright (c) 2021, Marc A. Borrelli

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The Greatest Own Goal or the Greatest Collapse

The Greatest Own Goal or the Greatest Collapse

The European Super League collapsed within days of launch due to hubris and the founder forgetting the key parts of their business model, value creation, sales, and value delivery. The collapse might bring a high price.