Your people are one of the biggest assets you have in your business. And to keep your team engaged and motivated, you need to keep them suitably rewarded. But the level of compensation you pay out to your employees can also have a direct impact on the profitability of your business.
In short, the more you pay out in compensation, the less end profit you leave in the business. So it’s important to get the balance between team compensation, team engagement, and profitability right if you’re going to build a stable future for your company.
Team compensation is a cost you can control
Team compensation is one the largest controllable expense in your business.
In order to produce your products, or deliver your service to customers, there are certain operating expenses that you’ll have to incur. But the salaries and wages you pay to your people are one area of those costs where you do have a significant amount of control over the end figure.
Ultimately, you decide on how many are on your team, the salary levels you pay to your team and the other bonuses and rewards that you pay them. So, although compensation is an inevitable expense, it’s not a constant – it can change over time.
To understand the true impact of salary and remuneration on your business, you need to look at your compensation figure in relation to your gross profit figure. What you get is an incredibly useful key performance indicator (KPI) known as your ‘labor efficiency ratio’ or LER.
How your labor efficiency ratio links your profits
Every business’s LER will be different and unique, but it’s vital that you track and measure this KPI over time and link it back to the overall profitability of the business.
As the business grows, you’ll also look to expand your team. But if you’re looking to hire a new person or persons, you need to recalculate your LER with the addition payroll costs added in and see what affect it has on your acceptable level of profit.
In short, the LER figure tells you if you can or can’t afford to take on this new person.
As we outlined last month, your acceptable level of profit (ALP) is the ratio you use to measure the profitability of your business. And, as with your LER, your ALP is a number that you do have control over.
The desired profit number that you set for the business is a variable figure within the equation. You decide on the profit you want to make and can flex this figure to fit your circumstances as they change over time.
So, as the business owner, CEO or management team, you do have a substantial amount of control over the impact that compensation has on your future success.
- Your overall team compensation is not a constant, and can be changed to fit the needs of the business.
- Your desired profit is also not a constant, so your ALP number can be varied accordingly to balance the ratio between salaries, team engagement and overall profitability of the business.
Greg Crabtree, author of ‘Simple Numbers, Straight Talking, and Big Profits!’, has long argued that labor and remuneration are the key factors in creating a successful, profitable business. To quote from one of Greg’s many insightful blog posts:
“Correctly measuring your labor productivity as gross profit per labor dollar will help you walk the tightrope of the right labor at the right time at the right price so you can hit your profit target.”
And what business owner wouldn’t want to have that level of detailed control and oversight of their financial wellbeing?
Tracking your LER
The size of your overall team, the number of people you hire and (in a very worst case scenario) the number of people you make redundant are all numbers that you and your management team can decide on – they’re flexible, movable and can change depending on the environment the business finds itself in.
You can decide whether to expand your team to take on lots of new people and have the potential risk of no work and a bunch of people sitting around being unproductive – and in doing so put your business on ‘life support’ where you’re just struggling to survive.
Or you can have a more balanced team, with a bit more profit to provide a safety valve, and then measure your LER and ALP to keep within the acceptable ranges for your particular business. The choice is yours.
And that’s why tracking and monitoring your LER is so crucial for any business, whatever its size or ambitions.
Your LER can be tracked in many different ways.
- Direct LER – this measures the compensation ratio for the people that render your services or provide the labor to make your product.
- Sales LER – this figure measures the ratios for the people in your sales and business development teams etc.
- Indirect/overhead LER – this provides the ratio for your admin people and other operational or management areas of the business.
Each of these KPIs tells a different story, whether it’s about your production process, your sales capability or your in-house administration and operations. But what they allow you to do is see how salary and remuneration are impacting on the business – and give you the information you need to bring about positive change.
Controlling and capping your team salaries
We’ve seen how team compensation can impact on your APL. But how do you come up with a reasonable approach to a salary that works within your agreed LER numbers?
I’m not a sporting man, myself, but sometimes a sports analogy checks all the right boxes when you’re looking to explain the complexities of running your own forward-thinking business. So, here goes…
In the US baseball leagues, every team had a salary cap. So there’s a bucket of money, that’s limited by that agreed cap, which the team must distribute fairly to pay the various team members in their team. It’s a simple concept, but one that can really stop the teams from overspending, or lavishing too much money on one particular player – it builds cohesion in the team, and efficiency in their finances.
I’d strongly encourage you to adopt a similar approach for your business and to put a salary cap in place, based on your own unique ALP figure. And doing so is a reasonably straightforward process:
- Figure out your ‘desired profit’ number for the business at this point in time (the key number in your ALP).
- Tie that in to the salary cap number that will be needed to achieve your ALP.
- Run your business around these key numbers, in the same way, you would if you’re a baseball team.
Helping you get real control over your financial numbers
Here at Holden Moss, our goal is always to help ambitious business owners to realize the true potential of their company.
Unlike some accountants, we don’t just deliver the numbers and KPIs and then disappear. We’re here to help you interpret and analyze your KPIs and give you proactive suggestions on how to improve them.
That’s the core vision behind our Awesome 8 approach to business advice – and, in particular, how we help your business to improve its profitability and financial control.
If you’re struggling with compensation and remuneration issues and trying to pinpoint the link between your team’s salaries and your failing profits, please do come and talk to us.
Get in touch with your local office and arrange a profit improvement session with one of our team. You’ll soon get on top of your compensation and profit issues and will see the positive impact on your long-term success as a business.