Many closely held businesses are seeing significant increases in revenue despite slow overall economic growth. With those increases, pressure can be created on people and systems to the point where you’re confronted with finding quality people and investing in systems to support your growth. Those investments of people and systems may have come at significant cost. So, how do you construct your budget and incorporate some changes in it to improve operational efficiency and effectiveness.
Efficiency is defined as “doing things right,” and effectiveness is defined as “doing the right things.” What things should I be looking at in my budgeting to accomplish this?
Budgeting in a Service Business
If you’re a service business, you’re not selling or manufacturing a product. So your budget has revenue and cost of services (labor). You have direct labor (billable) and indirect labor (not billable). I’ve talked in recent blogs about a net multiplier and labor utilization rates.
Net multiplier is the markup between direct labor and revenue and is calculated as (revenue/direct labor). Of course, you’d like for your markup to be as high as the market will bear. Part of this will be based on whether your service is viewed as a commodity or if there’s high perceived value. I’ve seen a range of net multipliers as low as 1.2 and as high as 2.
When setting your budget for 2017, calculate what your net multiplier has been historically to give you a benchmark to budget against. If you’re budgeting a multiplier of 2 when historically you’ve accomplished 1.5, then you have to ask yourself the question of how you expect to accomplish that.
Budgeting in a Retail or Wholesale Business
If you’re selling a product then your markup, which is the difference between what you bought and sold the product at, is your best way to accomplish operational efficiency and effectiveness. Your markup is calculated by taking the cost of the product, $100 for example, and increasing it by a percentage. If you sell that product for $150, then your markup is 50%.
Generally a 1% increase in what you sell the product for or a 1% decrease in what you bought the product for can have a 10% improvement in your overall net profit margin after overhead. When’s the last time you had a price increase? Has your supplier given you price increases that you haven’t been able to pass on which have detracted from your overall gross profit margin. To improve efficiency and effectiveness, consider finding another supplier that will sell the same quality for less or increase your prices.
When setting your budget for 2017, check your historical markups and see if you’re trending positively or negatively. The ability to increase markup may be in part a function of competition, whether your product is perceived as a commodity or other factor. However, if you budgeting for a markup of 75% when historically you’re trending close to 50%, you have to ask the question as to how you’re going to achieve a 25% reduction in cost or increased prices or a combination. It may not be reasonable given competition or other factors.
Budgeting in a Manufacturing Business
A manufacturing business has an element of labor and materials embedded in their cost of goods sold. Historically, a car manufacturer used assembly line of materials and labor to put the cars together. Now in a world of automation, many manufacturers are using robotics in lieu of labor, in part to control costs and improve efficiency. Manufacturers also look at markup similar to wholesaler and retailers. However, a manufacturing business is usually an asset intensive business because it takes a lot of fixed assets, like robotics and a physical plant to manufacture the product. So, markups are sometimes slimmer.
Because margins are slimmer, a 1% improvement in revenue or a 1% decrease in cost of goods sold can have a higher impact on a manufacturer than a retailer or wholesaler. Manufacturers are looking to offer incentives as a way to increase prices. 0% interest for car loans is one way that car manufacturers do this. They subsidize the cost of the financing and build it in to the price of the car.
Using robotics or increased automation has been an attractive way for manufacturers to reduce costs recently. While it usually requires a large investment in fixed assets initially, over time the cost per unit manufactured goes down due to the improved efficiency and effectiveness.
When budgeting for a manufacturer, sales rules apply. Look at your historical markups and use that as your initial factor for determining future gross profit.
Budgeting is part science and part art. However, a good starting point is looking at historical markups and net multipliers to determine where to begin.