One of the most important skills in running a business is identifying the key numbers and metrics that will drive the business forward and help the owner ensure that her or his business is healthy and moving in the right direction. At the same time, the ongoing demands of operating the enterprise often overwhelm every last moment of the owner’s day-to-day activities.
With that in mind, it’s critical that time be set aside for owners to learn more and identify the numbers that are most important to their success. It’s for that reason that Haines & Lagerquist CPAs holds periodic workshops designed to help small business owners become more conversant with the numbers that drive their business.
Most recently, Sylvia Lagerquist, CPA hosted a set of five business owners for an interactive session in the firm’s “What’s Your Number?” workshop series. Participating CEOs included leaders of firms in the communications, landscape architecture, graphic design, healthcare IT, and government contracting sectors.
The big takeaway from this session was the critical nature of understanding and managing the relationship between costs and prices, and being acutely aware of how dynamic that relationship really is.
Oftentimes, costs can vary widely and this is not fully accounted for with precision, the result being that a company can make significant profits on one project or customer and lose significantly on the next, without clear visibility to this up-front. In order to get a better handle on costs, the key is to clearly define each of your cost categories, particularly direct and indirect costs.
The Risk of Lost Time
One common challenge in professional services specifically is the risk of lost time. If the project budget is based upon the idea that a $150 per hour resource will be working 100 hours on a project and a $75 per hour resource will be working 100 hours, the anticipated cost will be $15,000 for the first resource and $7,500 for the second one — i.e. $22,500.
Now, imagine if the actual project involved 125 hours of the $150 per hour resource and 125 hours of the $75 per hour one. The total cost to the company of those two resources on this project would now total $28,125. Put another way, that difference could find you going from profitable to underwater, all on one project, and in the blink of an eye.
The Importance of Burdening Your Labor Costs
Small business owners often forget to include fringe benefits, overhead costs, general and administrative (G&A) expenses and profit in their labor costs, and this can be lethal. That’s why smart business owners need to focus on calculating and working against burdened labor rates that take all of these factors into account.
Staff Efficiency & Realization
Another common weakness in pricing strategy when professional services are involved is to inaccurately or imprecisely compare actual staff time on a project task to what’s anticipated in the project estimate, bid or proposal.
This can happen in two ways. One is to overestimate staff efficiency (i.e. you think that a junior staffer can complete a research task in three hours but in reality it takes them five), and the other is to underestimate client demands (i.e. you plan for two rounds of revisions to a deliverable in which each round takes two hours of staff time, but in actuality it takes an average of three rounds that take three hours each).
Material Costing: Methods & Impacts
In addition, businesses with material products that are either ordered to the job or ordered for inventory often fail to consider the impact of material cost changes on the project or deliverable for their client. For example, if your residential remodeling business is retained to construct a small outbuilding and half of the lumber you use is purchased at price “x” and half is at price “y”, it’s essential to plan for this risk up-front. Another factor is inventory control.
Let’s suppose your business repairs small trucks and you try to keep three to five transmissions as part of your in-house inventory. If you purchased one of them direct from the manufacturer at a retail price of $5,000 and another you purchased from an authorized warehousing distributor for a discounted price of $3,000, how do you account for that difference when both transmissions are otherwise identical? This is why your inventory costing strategy has to be defined up-front. The three main methods for inventory costing are First-in, First-Out (FIFO), Last-in, Last-Out (LIFO) and Average cost. Talk with your small business CPA about selecting and applying the best method for your business.
Accounting by Sector for P&L Precision
Another serious challenge that can derail many small businesses is not understanding the widely variable economics and other factors between different markets they may serve. For example, a paving contractor that serves both residential and commercial clients might need to track these two sectors distinctly to ensure that one side of the business is not subsidizing another.
Another area where this becomes critical to understand is the differences between commercial work and government contracts, where it may be essential to be aware of how different project and operating costs impact the overall profit-and-loss. In the government example, it might be that the actual core delivery of the project might be lower in cost when compared to the same work for a commercial client, but on the other hand the government project might require more accounting, more reporting and more overall management during the engagement.
Planning for New Costs as You Grow
Finally, it’s essential to understand where the inflection points lie in your growth process. Specifically, you might be able to take on two or three new clients without significant increases in overhead costs, but if you take on five new clients it might require multiple new hires, larger office space, and other resources that can significantly increase your costs going forward. This is why you need to analyze and understand how much capacity for growth your current infrastructure and personnel can support, and where new investments will have to made as you expand.
In summary, there are many moving parts that impact the nature of your business and both its cash flow as well as overall profitability and capacity to grow. By becoming more conversant with these priorities up-front, small business owners can make better pricing decisions, create more precise bids and proposals, and set their business on a stronger path for the future.