Crabtree 4 keys: Key 2 A New Breakeven
“Revenue is for show and Profit is for Dough!”
Greg Crabtree, author of Simple Numbers, Straight Talk, Big Profits is devoted to helping entrepreneurs build their “economic engine” through his firm, Crabtree, Rowe & Berger, PC, which recently merged with the nationally recognized accounting firm of Carr, Riggs & Ingram, LLC (CRI).
By calculating efficiency and creating company and individual benchmarks, Greg has founded a system for rising profitability.
As all entrepreneurs and business owners know, profit is the lifeblood of every business. If your business isn’t profitable it will eventually fade away.
Instead of focusing on Revenue, Crabtree urges, focus instead on Gross Profit:
Revenue - COGS (Materials + Subs) = Gross Profit
He also suggests not including your direct labor costs into COGS, by omitting direct labor it allows you to see the true economic engine of your business. It also enables you to make clear choices of how to use Labor to drive growth, which we will show in the next week.
But first there are a few things to review from last week. This article is a second in a series of four introducing what Crabtree calls the 4 Key Indicators.
Here are the key financial indicators, how they work, and how failing to understand them leads to recurring problems that can kill your business.
Confusing profits with salary: Crabtree says one of the most important things an entrepreneur should learn early on is this: “You get paid a salary for what you do, and you get a return on what you own.” When business owners don’t pay themselves a market-based wage, and include that expense in their financials their net income number is misleading. We covered this last week.
Breaking even isn’t good enough: The goal of every business owner is to make a profit, but that should be on top of getting paid for the work they do. If you are just breaking even, after paying expenses, taxes and yourself, you’re not profitable enough to grow the business. We cover this in depth below.
Productive means profitable: Nothing sustainable happens without labour productivity. And the best way to get control over your profits is to make sure you are getting the maximum productivity out of every labour dollar you spend. This does not mean working people harder, this means getting the right people in the right spot. Which we’ll get into more next month.
Know where the money goes: Many business owners get in a cycle of seeing money come in and go out of their business with no clear understanding of where, and why, it’s going. Crabtree urges owners to master the “four forces of cash flow” that suck money out of their business: paying taxes, repaying debt, building working capital and taking profit distributions.This will be covered in more detail next month as well.
Once you have mastered these concepts, growing your business becomes a dance between profitability and growth. To grow you need qualified candidates working for you and in order to pay them, you need the work. But before you can even hire qualified candidates, you need to gain control of your profitability and grow strategically.
We’ve all heard the idea of breakeven. Wikipedia defines it as “The break-even point (BEP) in economics, business—and specifically cost accounting—is the point at which total cost and total revenue are equal, i.e. "even". There is no net loss or gain, and one has "broken even", though opportunity costs have been paid and capital has received the risk-adjusted, expected return.”
Logically you would assume this is what you are aiming for but it’s really not.
According to Crabtree our current breakeven is not an accurate estimate of what it takes to actually survive. Instead, he suggests, using a 10% profitability percentage, pre-tax, as your break-even point:
At breakeven your company is likely already dead.
At 5%, a company is on life support.
At 10%, you’re a good business.
At 15%, you’re a great business.
Anything over that point, he advises, should be taken while it lasts because it will be gone quickly.
Crabtree also details various profit terms, cautioning business owners to be careful with the language they use.
He singled out “earning before interest, taxes, depreciation and amortization” (EBITDA) as the most abused term in finance.
He prefers “pre-tax profits,” as it’s easier to define and more traceable to true cash flow. He considers “revenue” to be a vanity number, preferring “gross profit” instead, as it includes revenue less direct cost.
In order to get your business up to a 15% pre-tax profit, Crabtree recommends knowing your current capacity and understanding the importance of being profitable and maintaining market growth in order to encourage growth.
As your business grows from $1-5M in revenue, it will pass through what he calls a “blackhole”.
To survive the business owner must do a few things correctly.
The most important resource you need will be extra manpower. He outlines eight functional areas to be ready to allocate resources towards:
IT & Tech Development
In single owner businesses, most often the owner wears all the hats with the exception of one or two which they outsource or delegate.
When you hit $2M you have to think about expanding your business’ infrastructure to include these eight areas. As you do consider what tasks you can delegate first that will help the business grow, where your own limited understanding and knowledge may be impacting your gross profit the most.
Hire with care as you grow
Even though we have to hire the right people, we want to add those labor costs at the last possible moment.
Hire slowly, fire quickly.
Crabtree suggests reading Topgrading: How Leading Companies Win by Hiring, Coaching and Keeping the Best People by Bradford Stuart to get you started on how you choose to hire.
He also strongly recommends using personality profiles as part of the screening process so you understand what makes that person tick. He suggests using Caliper Profile from Caliper Human Strategies.
Another successful approach is hiring young talent and investing in their education. Hiring people straight out of college, they don’t know a lot, but they also don’t have a lot of things to unlearn. You have the opportunity to coach them as they are often like sponges and they want to absorb knowledge and information.
A capital safety net
Either from reserving profit or seeking funds from investors or the bank.
What is your capital safety net? To calculate how much cash you need to hire the people you need, then estimate how long it will be before your business can pay the new hires and still remain profitable.
Forecast instead of budget. It’s not sufficient to just forecast net income; you also need to forecast cash flows and capital requirements. This will help you know if you have enough resources to get through without raising capital or borrowing money, which is ideal.
Live off your market-based wage
Leave every dime of profit in your business as you grow. Leave the profits in your business to fund the growth rather than relying on debt or investors. That's the whole strategy behind paying yourself a market-based wage (See Week 1).
Once you get past $5M these same principles apply, just with larger numbers. Hopefully, you have developed a team of people to support you in the process.
When it comes to profitability, you have to balance these ideas. But if you don’t get the owner compensation right, our profit number will be distorted. This distortion decreases as you approach $20M -$30M, but when owners are at $5M or less in revenue and play games with their compensation, they’re messing up the data that could tell them how healthy their business is.
Our next article that focuses on Crabtree’s 4 keys is Labor Productivity and how labor is the key to surviving this black hole which anyone growing their own business will find themselves in.
The teams that win are the teams that get the most productivity for every dollar of labor. That does not mean paying the least amount, it means creating ecosystems that support learning, growth and retention.