Last in a Series on Benchmarking
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| Alan Hanbury Jr. Contributing Editor |
Over the course of nine columns, we have talked about some 25 business metrics that one can track and benchmark against. After we collect them for a period of time, they begin to have a "normal" range. We can then apply these numbers to make better predictions and to make better decisions when things don't go as we hoped they would in our original plan.
You want your business to look like something specific in terms of revenue, margin, employees, net profit, dividends, pension benefits, etc. If you have business hopes, you need to write them down, so they can be considered a plan, not a wish list. Budgeting puts the meat on the business plan and tells us if it is too aggressive, not realistic, requires hiring or firing, or if we need to search for funds.
When a company — yes, the owner, but also key employees and production staff — meets to formulate next year's business plan, many of the items that go into making it a living document are financial in nature or can be reduced to their financial impact: asset needs, human productivity issues, or marketing costs. Budgets for marketing, personnel, capital purchases and sales, margin and net profit all need to be calculated "pro forma" — before they happen — to see what the plan looks like a year or more away. This is best done with any spreadsheet software, no matter how simplistic.
After you have entered all the financial changes that next year's business plan might create, run the numbers in the spreadsheet as if they actually happened. For example, you can run a pro forma income statement to see if you make money at that volume and level of expenses; if you can move up some longer term goals into this year's business plan; or if you are going to get hammered if you follow through on the plan as envisioned. By tweaking volume goals, raising margins, or changing work focus (for example, residential versus commercial remodeling), you can often still make the plan work.
The key here is that we need to know this before we start, not in September 2006 or on April 15 the year after. Most accountants simply come in and bayonet the wounded. They need to provide armor and be the early warning systems for our business success. If your financial professional does not give you managerial advice, tools or benchmarks, he or she is merely a bookkeeper who keeps your tax liability accurate.
After the first quarter of 2006, you can compare your assumptions to what actually happened. Enter the actual numbers in a column to the right of the pro forma column, and see how far off you were on each line item, on groups of items, margins, operating expenses, net profit, you name it.
This variance analysis allows you to have nine months to find solutions to any shortfalls, to implement strategies to make your business profitable, and to not burn up too much cash trying to make plan at all costs. The sooner you find shortcomings in your pro forma, the quicker you can formulate a strategy to mitigate that negative trend.
We can predict sales by looking at our human assets (sales per field, sales or total management employees). We can use total assets (sales to assets): cash, inventory, investments, tools, trucks and technology. We can use company net worth (sales to equity). We can use leads received, qualified or closed. We can use inflation or a multiplier based on market conditions.
We can also use the cost of goods sold from the previous year and apply an increased markup to it, thus producing more revenue without doing one more job. Your pro forma revenue and overhead spreadsheet will tell you if that tactic will work.
With five or six predictions of what sales might be, it is a lot easier to see the one or two that represent reality. There are several reality checks to help determine the most accurate prediction.
Factor in hours available for sales calls, commission or sales wages, and marketing costs. You may find that the extra marketing expense required to grow sales would eat up most of the margin produced by those extra jobs. Don't assume that there are not diminishing returns on your expenditures.
Now, how much working capital do you have? If your working capital is negative, you should get your house in order before planning any growth. If not, multiply the dollar amount by 10. This is the maximum increase in sales that can safely be added. If your plan figure exceeds this figure, it is time to get a line of credit or plan for other funding should your pro forma not go exactly to plan.
Next take a look at the production side and see if you can produce that much work given your present staff makeup and skill set. Say you have a field crew of six historically producing $375,000 per person. Can you expect to squeeze $2.5 million out if them next year? Not likely. You would have to hire one more field staff. If you plan to increase your sales to $3 million, you could enter a growth-related death spiral thanks to training, communication and management issues.
Things like the owner's compensation and benefits, travel, entertainment, training, networking and giving back to your community need to be in the plan. Track overhead before owner's compensation so you can identify costs that need to be undertaken whether or not you are having a good year. Look at net profit before owner's compensation for similar reasons. We need to take care of what it takes to run the business first and then we can be flexible with how much the owner will get.
Now comes the hard part — breaking the budget down by month. Assuming you pay weekly, remember that four months will have five payrolls instead of four. They will skew overhead expense for wages, benefits, taxes and any accruals attached to pay. Some expenses occur only once a year, so you will only enter them in that month. This is important for doing cash-flow statements, which every remodeler should. Knowing your cash flow can be the difference between making payroll or making a trip to the loan officer when a loan repayment, insurance deposit or annual payment is due.
We cannot accurately predict net profit because so much depends on last-minute, end-of-year accounts payable and receivable. Stock sales, depreciation, profit sharing and other choices that can be made at year-end can radically affect the final net profit tally.
We suggest 10 percent of sales for younger companies so they can build a nest egg. For a more mature firm, lowering net profit targets and raising owner's compensation or benefits or pension planning might be the more prudent use of dollars.
A target for retirement benefits is a must these days, because we can't depend on Social Security. You should put away 10 percent of owner's comp each year, whether via the company or individual savings. Don't overlook your employees, your most valuable asset.
Make sure education and training are budgeted for your staff. Education is an investment. Balance profits with growth and employee retention might just not be an issue. Train so delegation of responsibility is possible and time off will be less stressful.
Look at the amount of time you take for personal time, family and pleasure. Will your plan end your marriage while saving your business? Will it cost you time that would have been spent with friends, in a sport you love, or with young people who need your time? Are your hours going up but the results no better? You probably are not being efficient, or are so tired at the end of a day or week that those extra hours are wasted going through the motions. A hire, part time at first, might be the answer to keep your sanity and your business. The budget will tell you how much you can afford to spend; your time card tells you how much they have to do in hours. Often, much of what we do can be done by people earning $15 an hour instead of our own $100 per hour rate.
Now let's look at the balance sheet. Knowing our revenue and our target accounts payable and receivable turns, we can propose acceptable ranges for accounts payable and receivable at year-end, quarter-end or week's-end. We want to keep working capital at a level that will sustain revenue growth. We can then figure out how much of our assets should be kept liquid, and how much can be spent on trucks, real estate and computer equipment. We can predict what our long-term liabilities will be from how much we will pay down our past balances. Although predicting balance sheet items is hard, it is important to do some major account predictions and leave the small stuff for monthly assessments.
If you need to change some assumptions because of poor market conditions, you can easily see how much you would save if you cut out a purchase or benefit: The dollars simply fall to the bottom line. Using your markup and gross profit formulas, you can also determine how much more volume and what pricing strategy you need to pay for any new purchase, program or person. So spending decisions during a year can all be quantified by knowing your produced gross profit margin percent.
| Author Information |
| Alan Hanbury Jr., CGR, CAPS, co-owns House of Hanbury Builders in Newington, Conn. For Alan's budgeting spreadsheet, visit www.housingzone.com/hanbury. |
Last in a series on benchmarking.