An update on the Industry Canada benchmarking tool
By HANK BULMASHManagement
Why do some businesses thrive while others, the majority, just manage to exist? That is a big question and it is something that business owners should think about a great deal. Not surprisingly, it is a major focus of business school enquiry. Many, probably most, businesses are run by crisis management – the problems of the day tend to dominate the thinking of managers. In other words, the way you spend your day depends more on your telephone than your brain. You can get some idea of that from the Industry Canada website’s information on HVAC contractors. The IC report is available at www.ic.gc.ca/app/sme-pme/bnchmrkngtl/rprt-flw.pub?execution=e1s1. When you go to the site, use NAICS code 23822 to generate the report that provides information on the income statements of HVAC businesses.
The report covers a lot of businesses. IC tracks over 19 000 firms in the HVAC industry and the web page divides them into quartiles by revenue. The bottom three quartiles are composed of about 15 000 firms. These companies have revenues of $500,000 or less and they really reflect the situation of self-employed persons – sometimes with two or three employees. The largest firms in the bottom three quartiles have salary expenses of around $125,000 including the wages paid to the owner. They may have pre-tax income of 10 per cent of sales.
The real businesses in the industry are among the 5000 largest firms – all in the top quartile. This quartile covers a very large range of activity. The smallest companies in the top 25 per cent have sales of about $500,000. The largest have revenues of ten times that: $5 million. The larger companies have a lower profit margin than the small companies. In fact, the smaller the business, the higher the profit margin. Companies in the fourth quartile, have profits of about 24 per cent of sales. In the third quartile, the profits are 19 per cent of sales. In the second quartile they are 10 per cent of sales and in the first quartile they are seven per cent of sales. This makes sense once you recognize that the smaller the company, the greater the percentage of profits that is a result of the owner’s work.
So we might see that a company with sales of $80,000 (in the fourth quartile), might earn profits of about $20,000. That is both a high profit percentage of sales and not much money. The high percentage is attributable to the fact that the owner will take a low salary from the company. That low wage expense leads to a high profit. In other words, the companies’ books for the bottom three quartiles and the smaller firms in the first quartile overstate profits because salary expense for the owner is understated. We all have seen small business owners working 12-hour days for inadequate remuneration. That is not a bad strategy if your business is really growing and the situation is short-term. Sadly in many cases that is not so, and being permanently over-worked and underpaid is the plight of many small business owners.
For a company with $500,000 in sales (a small business in the first quartile), profits are about 10 per cent, or $50,000, and the same observation holds. The high profits are a result of the underpayment of the owner. For a larger company, say $2 million in sales, profits are only seven per cent – about $140,000. But it is likely that those profits are real, not inflated by the lower than market wages of the owner/manager. A company with sales of $500,000 has labour costs of about 28 per cent of sales, or $140,000. The percentage of labour costs for a $2 million company is higher at about 34 per cent of sales – $680,000. The difference in the percentage of labour cost in those two companies, about six per cent of sales, accounts for much of the excess profits in the smaller company.
The fact that small companies have large profit ratios is one reason why companies do not grow. Growing can present too large a risk for an undercapitalized owner. It is hard to give up the perceived safety of a small firm with modest sales that is making enough money for the owner to live on in the hope that growing will pay off in the long run.
One of the things humans are good at is avoiding looking at the bad side of things. So it is easy for a small business person, working hard and dreaming of a better future, to convince himself that what he is doing now is actually building for the future. And the illusory high profit margin can actually convince the owners of small businesses that they are doing better than they are. The Industry Canada reports lead one to believe that optimism of that sort is simply wrong in most cases. Working hard is a strategy for staying in place, not for growth. You cannot grow without planning for it.
So why don’t more businesses plan for growth? First of all, planning takes time and energy, which is not easy if you are overworked already. Then to grow you need to develop capacity and building capacity is expensive. It means higher fixed costs, higher inventories and higher salaries – all to complete work that you might not be able to win. For many small business owners, the leap into the unknown is terrifying. And without a source of ready financing, it may not even be possible.
One way to reduce the risk is to develop a written business plan. A business plan is just a set of business goals with strategies for achieving them. It is hard to develop your business without this kind of structure. Without careful thinking, the problems of the day-to-day will use up all your time and energy. For example, if you need to increase cash flow, you need to turn your receivables into cash faster. To do that, you need to actively learn to keep track of them. You have to learn how quickly you are being paid and which accounts are problematic.
Preparing an aged receivables trial balance allows you to focus on customers who pay late. Once you know who they are, you can figure out how to deal with them. You may even decide that some of your problem accounts are not worth keeping. Most companies do this as an aid to growth. Freeing up the energy needed to service problem customers is one of the best ways to develop your enterprise.
The difficulty for many businesses, especially small ones, is that there are so many numbers to deal with, so many demands during the work day, and so little time that it is nearly impossible to keep track of everything. And even if you could keep track of everything, what would that tell you? You need comparisons to know if you are doing well or not. When an amateur golfer breaks 100, he can begin to feel better about his game. When he gets below 80, it is time for celebration. But how do you know if you are doing okay on inventory controls, or if your rent expense is out of line? The problem is, compared to what?
That is when the benchmark at the Industry Canada website can be useful. The reports provide only income statements – not balance sheets. But you can use your balance sheets as a start along with projecting the kind of income you will need to fund growth in order to discover what you have to do to really develop your business. <>Hank Bulmash, CPA, CA, MBA, TEP, is CEO of Bulmash Accounting Professional Corporation in Toronto, ON. He can be reached at firstname.lastname@example.org. See HPAC March 2013 (www.hpacmag.com) for more information on Industry Canada’s benchmarking tool.