Why are ratios so important when building a business?
Last week I talked about a client who is building his company on bad business instead of good business and I briefly mentioned some performance ratios that he needed to achieve in order to get things on the right path.
So, if I know nothing about his particular industry, how can I tell him what he should and should not be doing?
The answer is in the ratios. There are very few different types of business. Let’s take a look.
- Service companies. Their costs are almost entirely salaries and rental.
- Manufacturers. Their material costs are the highest of their costs, then come salaries and rental.
- Buy/Sell. These can be commodity dealers who work on low margins, but big numbers, supermarkets that do the same, right through to antique and art dealers, who work on very high margins but few sales.
- Capital intensive companies. Included in their costs are the high cost of financing and maintaining their production assets, like aircraft, ships and rolling stock.
Now, because of who we are, we find ourselves servicing mostly the first two of the above types. So, over the years, I’ve become familiar with the ratios that lead to decent profits. Here they are:
- If they mark up their hourly salary rates 2 1/2 to 3 times when quoting, they’ll be able to grow a good business. The result will be that their turnover should equal about two times their salary expenses, because there will be some unsold time. Less than that and they will not succeed.
- They need to mark up the materials by about 67% when calculating their selling prices. That way, their Gross Profit will be 40% and that should be enough to cover the overheads and leave a profit of 8% to 10%.
Of course, there’s more to business than just these margins, but if your margins are wrong, no amount of management will lead to success. As I mentioned to that same client. It’s all about the numbers!