The most successful Wealthpreneurs know the importance of profit in their businesses. If a business is struggling to improve its pretax profit as a percent of revenue, owners frequently attempt to reduce costs. But, based on my experience working with Wealthpreneurs, a key factor that is commonly overlooked is labor productivity.
Keep your eye on the prize!
It is easiest to monitor labor productivity when your business is below $1 million in revenue. As your business grows in both revenue and headcount, achieving a higher level of productivity for each dollar you spend on labor becomes a bigger challenge. When evaluating labor productivity, gross profit per labor dollar is a key indicator.
When pursuing revenue growth, many business owners add labor before gross profits increase enough to reach their growth goals. As a result of this classic mistake, they must correct problems that may exist in the 8 areas of their round table and rethink how to profitably operate their business.
This mid-course correction might involve shrinking the business from a revenue perspective, creating an opportunity to reduce headcount by retaining only core employees who are “A” players. If you want to consistently achieve targeted profitability levels, do not add labor until the last possible moment! As the owner, you want to remain productive in the business while continuing your management responsibilities.
Cash Reserve Benchmarks
- Maintain at least 10% pretax profit level at all stages of growth
- Take distributions only to pay taxes until all debt is repaid
- Reserve two months of operating expenses in cash
Wealthpreneur Lesson
Salary Caps At the Super Bowl
Since the 1994 season, the National Football League (NFL) has imposed a salary cap on the amount of money that NFL teams could pay their players. From an original base of $34.6 million per team, the maximum amount payable per season to players increased to $224.8 million for the 2023 season. No business owner understands labor inflation and productivity challenges better than an NFL team owner!
The most successful NFL teams focus on maximizing output for every dollar they spend on labor. Success on the field is directly linked to knowing when to sign veteran (more expensive) talent and when to develop new (less expensive) talent via the draft.
The New England Patriots mastered this concept, winning six Super Bowls and 11 American Football Conference (AFC) championships with quarterback Tom “the GOAT” Brady under center and coach Bill Belichick walking on the sidelines.
Picture yourself as an NFL team owner
You may not be the owner of an NFL team, but determining your salary cap is still the best way to achieve your targeted labor productivity. To find your salary cap, you need to know two things: your targeted pretax profit percentage (assume 10% at a minimum) and your total nonsalary costs.
To calculate your nonsalary costs, add up all your costs for rent, utilities, insurance, maintenance, licenses, basic supplies, communications, etc. These costs typically remain the same regardless of sales volume (in accounting jargon, these are known as fixed costs.) If your business sells products, include the cost of the products you buy or manufacture for sale to your customers.
Here is an example of a salary cap calculation. It doesn’t matter if your employees are full-time, part-time, family relatives, friends, or neighbors! The sum of their compensation plus owner compensation must be no more than the calculated salary cap amount. This table highlights how 10% and 15% pretax profit targets affect salary caps.
Computing Your Salary Cap
When computing your salary cap, consider using a bracketed approach. Calculate the cap with a minimum acceptable pretax profit percentage (for example, 10%) and a maximum targeted percentage (for example, 15%).
Make sure your total compensation cost falls within the two calculated salary cap amounts
Digging yourself out of the hole
Growing businesses often achieve a net profit in accounting terms while producing a cash deficit in the process. This phenomenon occurs when cash receipts from customers lag compared to costs incurred to produce the company’s product or service. By managing your salary cap, you can achieve greater levels of profitability and minimize a cash deficit that may occur during a high growth phase of your business.
The insights above were inspired by the teachings of Greg Crabtree. For those interested in additional information, I recommend his book, Simple Numbers, Straight Talk, Big Profits!.
