Did you ever think that instead of giving a person an annual raise it would be much better to empower them to give themselves a raise with a “win-win” comp plan? In today’s low inflation world annual raises amount to just 2-3% on average. That is not very much, but it takes the initiative away from them which is not the best way to motivate people.

A better way to stimulate people to produce is with a larger reward tied to the financial results that they produce. This is easy to do for people like sales reps, managers, recruiters and the like, where their production is usually measurable. Even for staff positions such as accountants and human resources personnel, with a little effort much of their contribution is measurable as well. So the key is finding out the financial impact one generates and tying a commensurate reward to that result. Those results can be paid out on a sliding scale so that the better the person does the greater the rewards are, as their contribution to the profit and value of the company go up even more.

Let’s work up an example for a sales rep. Their base salary is $50,000/year and they are currently generating $100,000/year in margin. Their current earnings are $60,000/year. If we gave them a 2% raise and they doubled their margin they would earn $71,000 or $11,000 more, while their contribution of margin less compensation (before burden) would have gone from $40,000 currently to $39,000 with a raise, but no increase in margin and $129,000 with a raise and twice their margin.

On the other hand if you created a sliding scale instead of a raise you might get a win-win combination without the risk of a giving a raise. If we apply a 9% commission for margin up to $50,000, then an 11% comm. on the next $50,000, 13% on the next 50,000 and 15% on the next $50,000 and cap the rate at16% on everything over $200,000 which would provide a substantially greater incentive to produce, enriching both the company and rep. Here at current production the rep earns the same $60,000 and if he does not improve the next year the company does not pay out more. If however he doubles his margin, he earns $84,000 and the company nets $126,000. In both cases the increase in contribution is about 3.2 to 1. The company does pays out a bit more in the sliding scale example, but under this program the company is more likely to both motivate their rep and retain them. It is a win-win for both parties and the slightly greater in payout is an insurance policy to achieve higher production.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

After a long holiday period when most people put business thoughts on the back burner, it’s time to get back to work again. With that in mind let’s gets a conversation going on retained earnings; that is, what it is and what is it good for.

What Is Retained Earnings? Retained earnings is of course the amount of profit you have accumulated in the business and not distributed to the shareholders. It is the sum of how much money you have made since the company was started and not taken out in the form of dividends. It may sound like a boring concept that only your CPA should be interested in, but has some rather important ramifications for the way you can operate going forward. At today’s historically low interest rates, it is a good idea to borrow assuming that your rate of return is decent and you can then finance your growth with cheap money.

What is it good for? Retained earnings allow you to borrow money from the bank. The bank is interested in their degree of risk in lending money which is called debt. One of the ways they measure their risk is how much risk you are taking relative to them taking, i.e. their debt. Your risk is the equity you have in the business which is your retained earnings plus whatever capital contribution was made. For many companies the retained earnings portion is the larger portion. This is known as the debt to equity ratio. If you have a negligible amount of equity and you are asking for the bank to carry the lion’s share of risk it is not likely you will get the loan. Although this ratio varies from industry to industry, and loan restrictions are tighter then before, most banks are looking to take on no more then a 2:1 ratio; that is where they loan $2 for every one $1 in equity, industry ranges go from 0.5 to well above 2, although there are many factors to getting a loan and you would do well to check with you bank to determine what kind of D/E ratio and other conditions that want in order to grant you a loan and then shop around to determine your best option.

Retained earnings also gives you the ability to use your internal cash to finance growth and shore up existing operations without relying on borrowing more then you would like. Say for example that you would like to use your line of credit to finance higher accounts receivable as many companies do. You can then use a combination of your current profits and your retained earnings for other things, such as: open new offices, hiring staff, increase fixed cost, buy equipment, increase inventory and supplies, etc.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

How do you use gross margin % (GM %), (or gross profit %) to run your business? These terms are often used interchangeably but are they often defined differently. Most people define gross margin $, as revenue (or sales) less the direct cost of generating that revenue; and GM % is GM $ as a percent of revenue $ which is the definition we use.

The question is: a) What is GM % used for and why should one care about it? b) What can happen if GM % is not used appropriately?

What is GM % used for and why should one care about it?

a) So what is GM % used for? The answer is for a “for profit business” is to make a profit, which we will define as Net Profit (NP). If one does not make a profit, eventually they will go out of business. NP is equal to GM $ – Fixed Cost. So at a steady fixed cost level, the higher ones GM $ the greater their NP. In general, the higher ones GM % the higher their NP will be, so one normally tries to increase their Gross Profit rate. This can be done by increasing their prices or decreasing their direct cost. Of course if one increases their prices too much, they might also reduce demand unless they can demonstrate that the higher prices they charge is clearly worth it to the client. The concern is will clients overall agree to paying a higher price without losing volume, so that one does not generate any more Gross Margin $ then before. Likewise, if one would lower cost too much they might unfavorably impact quality and/or performance which could again lower volume. So there is delicate balance of GM % that one needs. Various markets and customers react differently so that it is important to know the dynamics of your market as regard to price sensitivity and GM %.

What can happen if GM % is not used appropriately?

b) The next question is what will happen if GM % is used inappropriately? The answer lies in the trade off between GM % and volume to maximize NP. If one increases their GM % and does not significantly reduce volume all is well. But if a higher NM % is more then offset by lower volume and reduces NP that is counterproductive. The objective is to maximize NP not NM %.

Here is an example. Let’s start with a NM % of 20% and volume of $100, so NP $ is $20.

If NM % rises to 25% and volume is reduced to $90, the NP will be $22.50 so the result is better than before. If the volume is down to $75 however, the NP would be $15 which more than offsets the NM % gain. Thus if one is concerned about increasing NM % and does not focus on the more important impact on NP they can make the wrong decision.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

Optimal Management is the premier management consulting company to the staffing industry. We act as mentors to owners and managers to maximize their sales, profits and value of their company. We become an extension of our clients operations and are there for all of their staffing and business needs, from sales, marketing and compensation plans, to finance, M&A, general management and everything in between.

Everyone has their own style of doing things and what may work for one company, may not fit your operations as the environment that you are working in may not be conducive to your operation.

For example, a person might have been a successful manager in a larger organization where he or she had many people providing them resources, perhaps with a substantial support budget. In smaller companies additional staffers are often not available and the person that you hire may not be able to function as you anticipated without these resources. They can only produce with a team but not on their own.

Someone given the title of Manager may likely believe that they will have people to assign work to do to get the job done within a specific time frame and expected deliverables. They typically took personal credit for the work of the team they headed, but clearly they could not have been able to produce this work on their own. It is common to take credit for the results of others as a department manager.

These Managers who move to a smaller company may be in for a rude awakening, unless the full details of the job and its nature was fully explained to them at the onset of taking a new job; namely that they are essentially “the team” and they need to deliver these results on their own without the help of others. There is therefore little chance that the same results could be obtained in a smaller company under these conditions; take away the assistants, resources, researchers, technicians, funding and the like and ones ability to deliver will likely disappear, unless this Manager has trained his prior staff and infused all of the knowledge that these people had, and even in that there are not enough hours in the day for the Manager to perform all these jobs on his own.

This situation comes about too often as one doesn’t dig too deeply into a new manager’s background. And his hubris allows them to believe that they can be effective anywhere, and irrelevant of the operating environment. The company only sees a solid manager working for a leading company in the field that they are lucky to get and assumes that he or she can replicate what was created elsewhere and leapfrog the competition. The manager is wooed and given an assurance that he or she can do the same here with a promise tied to the future as the company. Such things as formal budget, action plan, risks and threats are not factored in to business plan instead of “just let me do it” often prevails with disastrous results. I have seen such situations with regularity; good money is invested and without a well thought out game plan resulting in failure after many months of moving in the wrong direction, costing lots of money and termination of employees.
We have only death with one element of “organizational fit” and there are many more. But clearly trying to fit a square peg into a round hole doesn’t work.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

For all positions that are responsible for sales and profits it is better to provide a base salary and a commission, an incentive or a bonus that is related to the performance of those people that are responsible for generating it. By instituting such a plan one can allow a person to in effect give themselves a raise based on their results, instead of bumping up their base and reducing their incentive to strive. By producing more sales, margin $, gross profit or bottom line income one can create a win-win comp plan for both the employee and the company. When performance improves all participate in the gain, when it decline all are likewise negatively impacted.

We can divide most all positions as either a) sales or profit producing, or b) required and necessary without having an easily measurable impact on the company’s performance. The former would include positions in sales, most managers and directors, CEO’s, order fulfillment and scheduling, etc. In the later group would be administrative assistants, receptionists, clerical positions and other staff positions. It is not that these jobs don’t impact profit, as many do, but it is usually difficult to measure their profit impact and it is therefore easier to provide a competitive base salary for these jobs and let them share in any company wide bonus that may exist.

For those positions that impact results one should structure a comp plan that reflects this. Sales reps are the easiest to do. For example, If a rep has a base salary of $50,000/year and brings in sales of $1 million at a margin rate (gross profit) of 25%, this represents $250,000 in margin that they brought in. One can create sliding commission scales so that the best producer gets a higher payout rate in order to retain them then a marginal producer that one does not have to compensate as highly in order to retain. For example, one could pay a 4% commission rate of the first $250,000, 6% on the next $250,000, pay 8% on the next $250,000 and 10% on $1 million and above. For a person with $500,000 in margin this would amount to a total compensation of $75,000 and a contribution of $425,000 (or a 5.7:1 ratio) for the company and for a million $ producer this would be $95,000 and a contribution of $905,000 for the company (or a 9.5:1 ratio). These values are before considering benefits, other costs and the fair market value for such people, but the concept is clear, that one can create a win-win comp plan that essentially lets a person give themselves a raise and act as a retention device at the same time.

For managers, their profit impact would be measured for them by their team’s performance. This process is similar to that above and can be refined by trial and error until the results are win-win for everyone and the manager, their staff and the company prosper.

We welcome your questions as to the challenges you face in order to grow.

To see all articles in this series please go to http://optimal-mgt.com/blog.

Optimal Management is the premier management consulting company to the staffing industry. We act as mentors to owners and managers to maximize their sales, profits and value of their company. We become an extension of our clients operations and are there for all of their staffing and business needs, from sales, marketing and compensation plans, to finance, M&A, general management and everything in between.