In today’s hyper-competitive business landscape, merely breaking even is no longer the benchmark for success. Greg Crabtree, author, speaker, and financial consultant has determined that a 10% pretax profit should be the new baseline for financial health and sustainability in any business. This chapter delves into why surpassing this threshold is not just ideal but essential for long-term viability and growth.
Understanding the mechanics of achieving and sustaining a healthy profit is crucial for entrepreneurs, business owners, and corporate leaders who aspire to elevate their companies beyond mere survival. Through a detailed exploration of the eight functional areas of business, the concept of the Black Hole in scaling ventures, and the pivotal roles of gross margin and direct labor, this article will equip you with the knowledge and strategies necessary to transform your financial approach.
Understanding Pretax Profit
"Profit is like oxygen- your business can't hold its breath very long without it."
Pretax profit, or earnings before taxes (EBT), represents the financial performance of a business before accounting for tax expenses. This metric serves as a crucial indicator of a company’s operational efficiency, as it isolates the profit generated solely from business operations without the influence of tax liabilities. Anytime that this post mentions profit, it is referring to the pretax profit.
You are probably familiar with EBITDA – earnings before interest, taxes, depreciation and amortization. Generally accepted accounting principles don’t consider interest, depreciation or amortization and real operating costs. While this is “technically” correct, it’s not practical. If you owe interest you have to pay real money to write that check and it takes cash out of your business. That’s why Greg Crabtree focuses on pretax profit.
Understanding pretax profit allows leaders to make informed decisions about investments, growth strategies, and operational adjustments, ensuring resources are utilized effectively to enhance profitability.
Why 10% Pretax Profit is the New Breakeven Point
"By the time you're at the breakeven point, your business is already dead."
Historically, businesses aimed simply to break even, but in today’s dynamic market environment, striving for a minimum of 10% pretax profit is essential. This benchmark is crucial for several reasons:
- Sustainability and Growth: A 10% margin offers a buffer to reinvest in business growth—be it through innovation, market expansion, or enhancing operational capacities. Without this buffer, businesses may struggle to fund growth initiatives internally.
- Risk Management: Higher profitability provides a safety net during economic downturns. It allows businesses to absorb unforeseen costs without jeopardizing their financial stability.
- Investor Appeal: Companies achieving greater than 10% pretax profit are generally more attractive to investors, as they demonstrate effective management and potential for higher returns on investment.
Comparison of 5%, 10%, and 15% Pretax Profit Scenarios
- 5% Pretax Profit: Operating at 5% pretax profit means your business is on life support. While better than breaking even, operating at a 5% profit margin offers limited scope for reinvestment and is less attractive to potential investors. It provides a narrow cushion against market fluctuations, making the business vulnerable in challenging economic conditions.
- 10% Pretax Profit: This level is considered the new standard for financial health in business. It allows companies to invest back into the business while maintaining operational resilience.
- 15% Pretax Profit: Companies operating at this level are in a robust position to capitalize on new opportunities, attract top talent, and negotiate better terms with stakeholders due to their strong financial standing.
If you’re operating above 15% markets are likely to change that eventually. By setting the benchmark above traditional break-even points, businesses can secure a competitive edge and ensure long-term viability in a rapidly changing economic landscape.
The Insufficiency of Merely Breaking Even
Many thriving businesses today owe their success to the implementation of strategies that pushed them beyond merely breaking even. For instance, consider a retail business that once struggled to cover operational costs. By adopting advanced inventory management systems and driving customer loyalty programs, not only did this business surpass the breakeven point, but it also substantially increased its financial security and growth potential.
This underscores a critical lesson for entrepreneurs and business leaders: aiming for a thin margin of safety by just breaking even is insufficient for long-term sustainability and growth. Achieving and maintaining a higher pretax profit margin provides a cushion that can help manage risks more effectively, foster innovation, and ensure the company’s longevity.
Gross Margin over Revenue
Revenue is one number that can be very misleading. It doesn’t demonstrate profitability or health of a business. If you focus on Gross Margin rather than revenue you get to the true engine of the business and you can compare most businesses in most industries side by side. For example you can take a service based business and a retailer and compare their “success” based on gross margin rather than revenue.
Gross margin can be calculated by taking revenue minus cost of goods sold. Costs of goods sold includes, goods, materials, subcontractors and other pass-through costs. Gross margin minus direct labor will give you the Contribution Margin.
Before you can begin to fix your pretax profit you must truly understand gross margin. You will measure your pretax profit as % of both revenue and as % of gross margin.
Gross margin also is used when calculating labor efficiency, a critical component to measuring and managing profitability. Labor efficiency is calculated by dividing gross margin by labor costs.
Role of Direct Labor in Cost Management and Profit Marginals
Direct labor comprises the wages of employees who directly contribute to the production of goods or the provision of services. It is a critical component of a business’s operating expenses that directly impacts gross margin.
Managing direct labor efficiency ensures that labor costs do not consume a disproportionate share of revenue, thus aiding in maintaining healthy profit margins. Effective strategies include optimizing workforce productivity, investing in training to improve efficiency, and utilizing technology to automate routine tasks.
Greg Crabtree emphasizes the use of the direct labor efficiency ratio as well as the management labor efficiency ratio when it comes to controlling costs and managing profits.
Exploring the Eight Functional Areas
When businesses surpass the $1 million revenue mark they typically face a new phase in which they alone can’t cover all of the functional areas of the business. Business owners must start hiring or outsourcing some responsibilities. If all eight primary functional areas can be covered while you’re making a market-based wage then the business isn’t profitable. There should be enough revenue coming in to pay not only yourself but all functional areas a market based wage. Owners should be able to define who is responsible for the following eight functional areas:
CEO
Most of the time the CEO is the business owner. However if the owner decides he/she isn’t the right fit then they may hire a CEO.
Sales
More importantly, sales management is the key function rather than the frontline salespeople. Someone should be in charge of sales goals, close rates, etc.
Marketing
Marketing is indeed a separate function than sales although the same person may be performing both jobs. The marketing function is in charge of getting more leads while the sales function is in charge of closing those leads.
Operations
Operations ensure that the product or service is delivered efficiently. Whoever owns this function makes sure everything runs smoothly and on time. They are the people who keep things moving forward.
IT and Technology Development
In today’s world, everyone needs some IT support. There needs to be one person responsible for owning the business’s information technology capabilities. Some of the tasks of this function could be outsourced but the main manager should be someone in the company.
Finance
Some of the tasks in finance could be outsourced such as balancing the books, payroll or basic financial reporting. However, someone internally should still be responsible and oversee this function.
Customer Service
There needs to be a dedicated person to ensure that what is being created and delivered is meeting customer expectations. The customer service function bridges operation and sales together so the customer gets what you say you are selling.
Human Resources
Human Resources play a critical role in recruiting, training, and maintaining a workforce that is skilled, motivated, and efficient. Beyond standard paperwork and responsibilities, whoever is in charge of the HHR function is most importantly responsible for the company mission and values. This person is responsible for tying culture, mission and values together with the team.
The Concept of the Black Hole in Business Scaling
The Black Hole in business scaling is a concept where a company reaches a stage in its growth where the initial business model that contributed to its success no longer sustains higher volumes of business without significant adjustments. The iconic “Black Hole” occurs between $1 million and $5 million in revenue.
This stage is characterized by increased revenues that do not translate into higher profits. This contradiction occurs because you are at a point in time when you need to add staffing and infrastructure to grow your business before you really can afford to.
Strategies to Survive the Black Hole Effect
“Hire slowly, fire quickly.”
Surviving the “black hole” involves strategic planning and keen insight into the cost implications of scaling. Here are some effective strategies:
- Have Extra Manpower: As you struggle through the “black hole” zone, the most important resource you can have is manpower. It’s critical that the primary 8 functions are taken care of or you won’t be profitable. Hiring the right people with the right skills sets paid at a market-based wage is absolutely vital to growing profitably at this phase.
- Hire with Care: Hiring the wrong people can be one of the most costly mistakes you can make. If you have to fire and repeat the hiring process you lose profits. If you have an unproductive employee you’ve added costs without increasing revenue which results in a drop in net income. Hiring should be based on an informed decision, not a trial-and-error approach. Sometimes the right hire isn’t the person in the room with the most experience. Be willing to properly train staff.
- Measure Profits Correctly: As mentioned previously you should be focusing on pretax profit instead of EBITDA. Once you reach $1 million in revenue your business should be reaching the 15% pretax profit margin. Businesses who can’t reach this level of profitability quickly are doomed to fail. Additionally, an owner’s market-based salary should be accounted for when determining profitability.
- Have A Capital Safety Net: To survive through tough times and growth you need capital reserves. Greg Crabtree recommends a “core capital target” of 2 months of operating expenses without drawing on credit lines. You should be very specific when forecasting monthly operating costs and making assumptions about cash flows and capital requirements. Some successful businesses seek out sources for their capital safety net. For example, they may seek money from investors, friends, family, venture capitalists, etc. Once they receive the additional capital they don’t ever tap into it. They leave it as their cash reserves in case they hit unexpected obstacles.
- Reinvest Back Into Your Business: Once you pay yourself a market-based wage, your profits should be reinvested back into the business so that you aren’t relying on debt or investors to grow. Reinvesting back into your business helps you grow your capital safety net and keep your business profitable while scaling.
By understanding the dynamics of the Black Hole in business scaling and implementing strategic measures to manage it, companies can continue to grow profitably without falling into the trap where increased scales do not correlate with higher profits.
Explore Greg's Books
Explore Greg's Books
Actionable Strategies and Tips for Business Leaders
Maintaining profitability is crucial for the long-term sustainability and growth of any business. It requires a proactive approach that prioritizes the optimization of resources, close monitoring of key performance indicators, and fostering a culture of continuous improvement.
Identifying Key Performance Indicators (KPIs) for Profitability
To steer your business towards the 10% pretax profit goal, start by identifying and tracking the right Key Performance Indicators (KPIs). Choose KPIs that directly reflect profitability and how much capital it took for you to generate that profit. At a high level, common KPIs that Greg Crabtree emphasized include:
- Gross Margin– Revenue less Cost of Goods Sold
- Contribution Margin– Gross Margin minus Direct Labor
- Pretax Profit– Earnings before taxes
- Return on invested capital (ROIC)– Should be at least 50%!
- Labor Efficiency Ratio– Gross margin divided by direct labor
- Core Capital Target– Cash reserves equal to a minimum of 2 months of operating expenses
You should be monitoring these on a consistent basis and forecasting for the future.
Regular Financial Review and Planning Sessions
Holding regular financial review and planning sessions is crucial. These meetings should be conducted monthly to allow timely adjustments to your business strategies. During these sessions, review your financial statements, compare actual performance against your budget, and forecast future results. This process not only helps in maintaining focus on financial goals but also promotes an agile response to market changes.
Encouragement of a Culture Focused on Continuous Improvement
Cultivating a culture of continuous improvement can play a pivotal role in achieving and sustaining profitability. Encourage your team to always look for ways to enhance efficiency and reduce costs. Initiatives could include streamlining operations, adopting new technologies, or improving supply chain logistics. Recognizing and rewarding employees for cost-saving ideas or profit-increasing strategies can further reinforce this culture.
By implementing these actionable strategies, business leaders can elevate their financial performance, surpass the breakeven point, and achieve higher sustainability and growth. Each step, from tracking pivotal KPIs to promoting an improvement-oriented workplace culture, plays an essential role in ensuring your business not only survives but thrives in competitive markets.
Scale Profitably Today
As we’ve explored throughout this article, surpassing the traditional breakeven point to achieve at least a 10% pretax profit is not just advisable; it’s essential for the sustained growth and health of your business. Embracing this mindset shifts your financial strategy from mere survival to thriving, allowing you to reinvest in your business and secure a competitive edge.
Don’t let complexity stifle your financial success. Transform your business through Greg Crabtree’s books, engaging keynote presentations, interactive workshops or personalized consulting services, to ensure your business not only meets but exceeds its financial goals.
Build a financial framework that propels your business beyond conventional boundaries and into new realms of profitability and success. Let’s make financial mastery a core component of your business strategy.
