Business Analysis 101

It is impossible to know how well you are doing if you do not keep score. And it is really difficult to improve if you cannot track your results. That is why athletes practice by competing against established metrics. In sports it is commonplace to recognize that what you keep track of, you improve. What you do not focus on does not get better.

The same is true in business. If you want to collect your receivables faster, the first step is to start keeping track of them and seeing how quickly you are being paid and which accounts are problematic. Preparing an aged receivables trial balance allows you to you focus on customers who pay late. Once you know whom 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 required 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 workday, 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 it 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: out of line compared to what?

There is an Industry Canada web tool that is very helpful in this kind of exercise. The benchmarking instrument is found at www.ic.gc.ca/eic/site/pp-pp.nsf/eng/home.

Go to the site and you will see a set of reports available for different kinds of contracting businesses. Select Plumbing and Heating, and you will be taken to a page dealing with HVAC contractors. You can generate reports for the industry as a whole, which covers statistics for over 20 000 companies with annual revenues ranging from $30,000 to $5 million. Broad stroke information like this is useful for someone wanting to sell to industry members, but it is too wide a selection to help you understand your own situation. It makes more sense to focus on businesses around your own size.

The tool allows you to select statistics for the four industry quartiles based on sales. The fourth quartile includes the numbers from the smallest 5000 companies in the group. The third quartile contains the next largest 5000 companies, and so on.

The companies in the lowest quartile are very small. Their revenues range from $30,000 to $82,000 – so it is pretty clear that these are startups or companies where the owner does most of the work and perhaps does not even work full-time. The third quartile covers companies with revenues in the $82,000 to $190,000 range. Again, the numbers are quite modest. This is a reminder that half the companies in the field are really one or two people working together with perhaps a single employee. The second quartile companies have revenues from $190,000 to $530,000. And the first quartile companies range in revenue from $530,000 to $5 million.

Looking at the difference between companies in the first and second quartiles is illuminating. First quartile companies have direct costs that are 64 per cent of sales. That figure includes direct labour (20 per cent) and materials (44 per cent). The first quartile companies have indirect costs of 30 per cent. That leaves them with a net profit before tax of just six per cent. The largest indirect cost categories are labour and commissions at 14 per cent, and insurance at eight per cent.

Cost breakdowns for second quartile companies are very different. Direct costs are significantly less and indirect costs are higher. Direct labour is 10 per cent (compared to 20 per cent for larger companies). Materials are 39 per cent (first quartile 44 per cent). Indirect costs are 41 per cent of sales compared to just 30 per cent for first quartile companies. Net profit for second quartile companies is 10 per cent of sales (compared to six per cent for larger companies). The largest expenses for second quartile companies are labour and commissions and insurance, the same as first quartile companies. But the percentages for these expenses are significantly higher for the small firms – 17 per cent for labour and commissions and 12 per cent for insurance (compared with 14 per cent and eight per cent for the first quartile).

Just this simple analysis tells us some interesting things, and it provides hints about future problems. If you want to make the jump from a mid-second quartile company (grossing say $300,000 per year) to a first quartile company (with revenues of say $1 million) your cost of production will rise. That is because you will be depending more on employees and subcontractors to do work that you may do yourself now. Your own salary will shift from direct labour to overhead, which is why direct labour costs for larger companies is a higher percentage, but with your increased sales, your overheads should decline as a percentage of your gross.

The key point here is that if it is going to succeed, your business will have to become more systematized as you grow. That is because you will need to depend more on other people. Decisions that can be made personally in a one or two person shop need to be formalized as the company grows larger. That requires an investment in strategic planning, which can sometimes be difficult. The reason why most companies do not make it into the first quartile is that the owners do not have the ability to convert what they personally do into a system that frees up their energies to develop growth. Most of us prefer to stay in our personal comfort zones. Growth is more difficult than it appears because it requires a change in behaviour.

If you decide not to grow, you can increase profits by becoming more efficient. Comparison tools are helpful for that, because they allow you to focus on areas of possible improvement for cost controls. On the other hand, if your aim is to grow, comparison tools are also important. They can help you formulate a plan to evolve your company into its next stage of development.  <>