Today, I was reflecting on some recent discussions about cutting cost. I write a hypothetical story here – no real persons and situations involved. Every comparison with reality is .. indeed. So just imagine: the management team or the board is meeting over the recent numbers. You can see them sitting around the table, staring at a spreadsheet or an accounting report. Some people are pointing at costs. “This should be reduced.” “That should also go down!” “Why is this so high?”. They get the detailed numbers on all the paid salaries. One manager points at the salary of a team member that is doing almost double shift in high-margin invoiceable services.
“Why do we pay this man so much money? Let’s go talk to him …”
Almost double-shift. So you can imagine, that consultant is earning a lot of money in paid over-hours. A more than nice salary, probably. Room for cost reduction? Sure! But, wait a minute. In reality, this man is also by far the biggest provider of company gross margin. In his team, half of the gross margin of the entire team is based on his efforts, and many of the other team members rely on his expertise to also go the extra mile. In two other teams half of the gross margin is also a result of the historic activities of the same man, leading to happy customers who keep on asking for more services in the other teams.
That information, however, is not visible in the balance sheet or the salary overview. So everyone in the meeting is focused on cost and salary, and no one ever thinks about the impact a reduction of that salary might have on the turnover and margin of the company. Or on the client satisfaction, and hence on future recurring revenues and margin.
So, yes, you can imagine they went to see him. They were surprised he did not buy their proposal. He was mainly disappointed about the lack of support for ‘the man in the arena’. Other people who performed less, got a salary increase, because that was ‘fair’. He, on the contrary, was asked to cap his salary, and work less as a compensation for that. After some time, they even asked him to leave the company. They all agreed that was better for the company, because he was way too expensive.
One day later, the balance sheet indeed looked a lot better. “Look, management did a great job!”. No one ever looked into the process that made the money come in, in the first place. Ever.
The issue is that cost calculus is done on historic data, reported about one specific moment in time, on a balance sheet that only contains details on cost. The calculus is almost never done on the end-to-end process. That’s why, in many cases, there is no reference to the effect of cut costs on the future margin.
Balance sheet mainly focuses on cost
The issue is that costs are very visible in the balance sheet – and balance sheets are the most important document used to evaluate the performance of a company. That is because in many companies, the budget is about allocating costs to teams, and the balance sheet helps visualize on what topics the money was spent. Where the money comes from, is some magic thing that just seems to happen automatically …
Details on turn-over and gross margin are much less visible in a balance sheet. Look at your companies balance sheet. Do a little math on your balance sheet, and compare the number of lines on cost versus the number of lines on income, or use the Lagast index, and check how detailed your income information is:
Lagast reporting client-focus index =
balance sheet lines about income / total lines of balance sheet
(c) Jan Lagast, 2019
- 0% < 5% classic cost-based balance sheet
- 5% < 10% balance sheet with basic income information
- 10% < 25% income-balanced balance sheet
Solutions to increase paying attention to income
I have to admit, I stopped adding income-related data to the balance sheets in most of my start-ups, because for many accountants it is a bridge too far to add that extra layer of information. That is why I add the client numbers in a separate document, when I am leading the meeting. Showing client life-time value is very useful, and when you rank the clients according to the Pareto 80/20 principle, rather than alphabetically, the biggest (recurring) accounts will always go first, when all minds are fresh.
Another solution is to use a Lagast 4-topic agenda, that starts with clients, and ends with financials:
- Clients (& markets)
- People (& partners)
- Offering (& processes)
- Financials (& investments)
That way, the meeting focuses on clients first, and the chances are higher that income is not ‘buried’ under cost in the meeting.
How to find the biggest earners, and keep them motivated?
When people provide paid services, it is also important to allocate the income (and preferably the gross margin) to individuals and teams. There is a huge difference between people working many hours, versus people creating a high margin. This requires you to at least measure the hours that are invoiceable, and distinguish them from total hours worked. What’s more, one has to understand what part of the gross margin is made by what hours, and understand what teams and inviduals are responsible for which amount of that money.
A balance sheet in services companies often does not even differentiate between time produced for clients, and time produced for the company. And if they do, it is not easy to read the information one needs from the balance sheet. Just like with income data, one often has to look into separate people and team production data first, in order to understand the process of who makes what money.
With the right tools one can get this information easily from the time sheets, though. That is why, some years ago, I had the app FunkyOps developed, and created a start-up for it. Now FunkyOps is one of the core products of FunkyTime. The advantage of FunkyOps is that one can easily get to the most important steering information for a services company: what are the gross margin drivers in the company?
As soon as you know where the money comes from, you can have a totally different debate. You might probably think twice before demotivating your biggest earners. Rather than cap’ing their salary, you might want to offer shares. Or you might want to reduce your dependency on one big earner, and add more colleagues or create extra teams? Three is better than one. And you’ll make three times the amount of money, so what’s the issue some people make a lot of money? This concept is well understood in football, where the top players earn much and much more than the manager. So why not use this concept in businesses too? Just reflect about it, and then look again at the numbers that are laying in front of you, next time you have your board or management team meeting.
And what about impact?
The higher-level question, of course, is “what is impact?” In the above chapters, I reduced impact to the impact of an individual on the profitability of a (services) supplier. I have spent half my career on helping to discover what client-impact and client-value really mean. And yet, I am still wondering how to measure and report that impact in such a way, it gets adopted by management or board members as their main instrument, rather than balance sheets.
As you’d probably guess, I am also thinking how to make a process support tool that helps teams to debate and report around client value or client impact. The results of those thoughts will appear in future scribbles on this blog. And they will be part of one of my latest ventures mission.
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