September, 2007

Do Your People Cost Too Much?

Operating expenses should be tied to gross profit—and a downturn is the time to examine that relationship.

By Bill Lee

If you are serious about reducing operating expenses, the place to begin is by making some tough decisions about the number of people on your payroll.

Even in the best of economic times—at least for highly profitable building supply businesses—managers strive to hold personnel-related expenses to no more than 45% of the gross profit the company is generating. But in years when the housing economy is less than robust, it’s easy for managers to let their emotions cloud their judgment and to allow people expenses as a percentage of sales and gross profit to get out of hand.

Since every expense on an income statement is best measured as a percentage of sales, it’s critical to reduce operating expenses by at least the same percentage as sales have decreased. And since people-related expenses make up the great majority of all lumber companies’ total operating expenses, it just makes sense to prune people when the prognosis for increased housing activity is not promising for the next 12 months.

Over the years, I’ve noticed that the closer personnel-related expenses (salaries, commissions, group medical, payroll taxes, and workers’ comp) come to 70% of total expenses, the nearer the company is to just breaking even or perhaps even losing money. While I’ll admit that looking at personnel-related expenses as a percentage of total expenses isn’t as good a measurement as looking at them as a percentage of gross profit dollars, I believe it is still a worthwhile benchmark to consider.

One of the primary reasons managers recite for their reluctance to downsize the work force to be more in line with the company’s overall productivity is that they feel responsible for their people. This can even be true for employees who are not pulling their weight in the organization.

An early mentor straightened me out on this issue, especially with regard to employees who are falling far short of management’s expectations. “Bill,” he said, “you’re not doing these people any favors by not terminating them. Just think about it…by keeping employees you’ve given up on on the payroll, you’re depriving them of the opportunity to get a job with another company where they might have a bright future.

This advice is especially applicable today. Most sectors of the North American economy are performing quite well. Many industries are in a hiring mode, so the people who may not be in your company’s future will not likely be out of work for very long.

Many of my clients were highly profitable several years ago when their sales were only a fraction of what they were at the peak of the housing market. Whether you call it “downsizing” or “rightsizing,” it’s an action step that must take place if a business is to remain profitable in spite of what’s going on in the local housing market.

Yes, housing will recover; I don’t believe there’s any doubt about that. But when it will recover is another matter. The good news is that regardless of what’s happening to your company’s sales, you can still make a satisfactory bottom line profit by controlling operating expenses to the same percentage of sales as you did when your business was at its peak. And the place to begin is with people-related expenses.