How to scale a company profitably

Greg Crabtree:

The number one spend that it takes to grow your business is marketing spend, and that can come in the form of is it spending on marketing or people that can carry a labor component as well.

Greg Crabtree:

The other one is pre-spending on capacity, which in general is labor that’s not fully utilized to then fill it up and sell into it. Now, in the scaling process, so the black hole that I talked about in the first book of between a million and five million revenue is painfully real, and $3 million of revenue is the deepest, darkest moment of the black hole. The reason for that is, is it’s where the next person or the next catalytic spend that you have to put out is far more significant to your overall financial picture than it is when it’s $5 million or $10 million or $20 million.

Greg Crabtree:

Yu got to get through that period before the catalytic steps that you take aren’t so critical between an edge of life and death.

Greg Crabtree:

Yeah, thanks for having me. I’m excited to speak to your folks.

Greg Crabtree:

Really, it came from the fact that I joined the entrepreneurs organization in 2001, which is not common for accountants. There’s more accountants in it now, but when I joined, I mean I was like one of a handful of accountants in the world that were members. In my forum, I was doing a presentation about what we did. I just happened to ask my other nine forum mates, who I couldn’t do business with, so I was in the same space. I said, “How many of you would recommend your current accountant,” and the answer was zero. It’s like they didn’t hate them, but they didn’t like them.

They might have liked them as a person which made it this uncomfortable relationship because well, it’s like I need them, but I really wish they could do this, but they say they can’t.

Greg Crabtree:

I said, “Okay, well tell me then what is it that you want to know,” and they said, “Well, the first thing is, is we don’t like the tax day surprise. It doesn’t matter where you’re at in the world, you got to deal with taxes for the most part, unless you’re just… even if you’re in a no tax country, but if you do business in a taxable country, you got to deal with taxes.”

Greg Crabtree:

Taxes, it’s the surest thing as death.

Greg Crabtree:

Okay, well let’s deal with that, but let’s predict it. Have you set the money aside irregardless of when the taxing authority tells you to send it in, so it’s not a surprise, because it’s not your money and it’s not going to be your money-

Greg Crabtree:

… and that led to a few other things about intellectual honesty about taxes of when are you truly saving taxes, versus when are you just postponing it to a different period.

Greg Crabtree:

I think there’s a lot of bad discussion around that concept of I always try to be clear when we tell somebody, “Well, I helped you save taxes permanently in this idea.” This one, “Hey, we just moved it from this year to next year, and I can’t guarantee that the rate’s going to be the same, so it is what it is.” He said, “Okay, well I got that.” I said, “I understand that and I think I’ve got some ideas already that I can fix that piece, just require some communication process. Good. What’s next?” He says, “Well, we don’t like being billed by the hour,” and this became… and a lot of people who’s going to listen to this podcast do business this way and that they bill by the hour.

I got news for you, this is going to shock you, but if you bill by the hour, there’s only two possible outcomes. I either gave away my expertise, or I charge for my ignorance. You never get to an economic equilibrium, and it’s essentially a lazy way of doing business because you don’t pre-plan enough to scope what really needs to be done and two, you’re not confident in crafting your offering to charge a market price to then make the cost fit. Really, we’ve proven this over and over again with our clients to get them off of an hourly billing mindset wherever possible to say, “What will the customer pay for this?” We see this in the contracting business that those cost estimating and job estimates all the time.

They fall into the other trap is that they do this cost build up, add a little profit, and they say, “Oh well, this is what we got to charge,” and I go, “No, no. You start with what is the customer willing to pay, now let’s see what is the least amount of costs it’s going to take to do it and how much profit can we make.” This is really what I would say is my passion that I’ve come to learn, but I didn’t know it existed as a formal course of study is behavioral economics. I mean I would say probably I’ve become a practical practitioner of behavioral economics to understand how humans interface with economic issues and questions. I want to stay away from manipulation, but I do like to help everybody get the optimization, understanding those things, so that hourly billing thing was just one of the big ones.

Greg Crabtree:

Today, everything we do on a consulting basis is all fixed price, and then the last piece I said, “Okay, what else?” He says, “Oh, well, oh by the way, you see hundreds of businesses most intimate details. You got to have some idea what works and what doesn’t.” To me, this was, what, just hit me right between the eyes. As a profession, we constantly do this. Now, we don’t. We really have made a study of looking at the data and saying. “What is all of this data telling us,” and now it’s a little more common for people to think that way, because of big data and all those things, but essentially study the data, study trends. I can’t share obviously intellectual property or trade secrets or those things, but I can certainly study the data to see trends.

One of the things we do today which has become hugely beneficial to our clients, we monitor 100 company model. One of the things that doesn’t exist anywhere in the world is real-time economic data on privately held businesses, what actually is happening. Every government is hamstrung because they know nothing about your business at the moment, literally nothing. When you talk to the economist at the central banks, you don’t want to know how they come up with the data I’m telling you-

Greg Crabtree:

… because it’s a little bit manufactured.

Greg Crabtree:

We said, “You know, this is a problem. I want to know.” Okay, well since our practice, we have programs all over the US and Canada, we have several clients in Australia so we get snippets, but we said, “Okay, well let’s focus on the US at this point, and let’s see if we can come up with our own index.” This is our simple numbers company model. It’s a billion dollars of revenue. I say that’s a pretty good dataset. It’s got a hundred companies. We didn’t just pick the winners and losers. We said, “Hey, there’s first hundred companies we can come up with we have data for this at least a minimum 3-year range of time, and we monitor it every month.”

I’m telling you the learning has just been off the chart fascinating, because what the economy is doing versus what the media and the government says it’s doing are just diametrically opposed. Now, last year so obviously especially during COVID, this is extremely fascinating to watch is certainly we fell off the cliff. That 100 companies was running about an 8% growth rate coming into COVID year over year.

Greg Crabtree:

Coming off of six years of double-digit growth rates mind you, so with the private company economy have been growing at a massive rate bigger than what anybody was reporting GDP was at, but it started to slow down because we ran out of labor. I mean literally in the US, we were just out of people. COVID hits and we just shake up. You see a 25% decline in April. You see about a 20% decline in May and then boom, June comes back a little bit as things try to reopen, settle back then and by the end of the year, we actually ended up in 2020 up 6%. Now, if you ask people what they thought happened in 2020, that would not be the answer.

Greg Crabtree:

Now the other thing is like we see trends, we specifically focus on things like marketing and we have marketing clients that we communicate with, but we also are big fans of effective marketing, and what’s the right number to spend and how do you leverage and scale your business with effective marketing spend, but it’s fascinating to see that the marketing spend for these hundred companies have still not gotten back to the pre-COVID levels. That’s telling you that the market does not believe that there’s open and willing customers in certain segments that are willing to buy yet. They’re holding back on that cash, and it’s going to release it.

These are the kind of things that my forum taught me to say, “Listen, you know, I mean nobody’s paying me directly to go look at that model, but it’s incredibly valuable insight that we can then share across our client base in our community, and really give them some tangible answers that other people are just making it up, and at least there’s some indication. You can accept that it’s not a big enough model. Okay, I get that, but I think it is.”

Greg Crabtree:

Yeah, absolutely.

Greg Crabtree:

This is this discussion that we have with entrepreneurs, and I mean it almost comes up every day. We had a client on the call earlier this morning that said they had some extra money says, “What do I need to spend it on?” I said, “Well, I mean you don’t need any cash.” I mean I said, “Your business is producing enough free cash flow that everything that they needed to grow their business with is an expense, but it’s a finite number that would not drive them to a loss. You just need to decide what is the catalytic spend that is going to scale your business. Now what we’ve learned from studying the growth path of all of our clients is this.

The number one spend that it takes to grow your business is marketing spend, and that can come in the form of is it spending on marketing or people that can carry a labor component as well. The other one is pre-spending on capacity which in general is labor that’s not fully utilized to then fill it up and sell into it. Now, in the scaling process, so the black hole that I talked about in the first book of between a million and five million revenue is painfully real, and $3 million of revenue is the deepest, darkest moment of the black hole. The reason for that is, is it’s where the next person or the next catalytic spend that you have to put out is far more significant to your overall financial picture than it is when it’s $5 million or $10 million or $20 million.

You got to get through that period before the catalytic steps that you take aren’t so critical between an edge of life and death of the business, and where you can’t afford to miss, whereas I can afford to miss if I’m at 10 million and I try the next test of something in that process, but then what it really came down to is 90 plus percent of the things that we spend money on to grow are an expense. It’s not a capital asset, it’s not a piece of equipment, it’s not a building, it’s not a plant or a factory, or those kind of things. I mean they can be, but even if you do those things, there’s a way to look at it from a practical standpoint of framing the return on investment of my choice to spend because the thing that struck us was it goes back to what we say there’s four types of capital.

Three of them exist on your balance sheet, one of them hides on your P and L. I think to me, that’s discovering the ninth planet of the universe. In a sense, it was sitting there in plain sight. We just didn’t have a telescope strong enough to see it. Okay, well the reason why is we had our mindset saying capital means balance sheet. No, it doesn’t. I’m producing profit on my P and L, and then making choices to redistribute that profit into something that I didn’t need to spend on to create what I’m currently doing. Every person that runs a business listening to this podcast, I want them to stop and think for a moment, what did you spend to try to grow the business in the last 12 months that wasn’t needed to be spent to produce what you did in the last 12 months?

You spent it to get to someplace else next. That’s not a current operating cost. It’s an investment in the future. It just happens to be on your P and L. What we’ve done is try to design techniques, and you’ll see a couple of these examples. The term we named the baby is the capital component on your P and L is called launch capital. It’s an expense that I use to launch an activity, whether it’s a business in total, a segment, the next new customer or whatever that. The key is putting words to it to give people… like what we did with LAR in the first book of labor efficiency ratio, we’ve named the baby. There’s two critical names that we really came up with in the new book.

One of them being trade capital, which is that key component of that cache that just turns over AR inventory minus AP. That component, it’s a slightly different derivation than working capital, but to me, it’s the accurate way of looking at, “Hey, this is the cash piece, this investment piece that as the business gets bigger, that dollar amount is going to get bigger, but it’s going to stay in relation to my revenue in this…

Greg Crabtree:

I do that.

Greg Crabtree:

Right.

Greg Crabtree:

It is absolutely.

Greg Crabtree:

Yeah. In essence, you’re sitting at the blackjack table, you’re on a good run, and you’re trying to say, “Well, this is the amount that I need to hold on to, but here’s the amount that I’m willing to bet, and I like getting the entrepreneur to think about launch capital is a bet. I don’t know if it’s going to work.” How many people have…

Greg Crabtree:

Absolutely.

Greg Crabtree:

Yeah, unless you’re in a business that literally nobody’s going to come to you without… you’re in a transactional business and if you don’t market, nobody comes through your door. To a certain degree, and this is what we do with our online retail clients, we consider direct marketing of social media, pay-per-click, those kind of things, that’s actually a cost of goods sold in the way that we look at online models. Now marketing for branding awareness, content, those things, that’s launch capital in those, because you can get by without spending anything and it won’t optimize the business, but you’ll keep getting business from that other.

Most the rest of service businesses, people that have a brand, they’re known in the community, I’ve got an oil change client that literally whether they market or not, somebody’s going to drive past their place. He says oil change, and they’ll go in and get their oil changed.

Greg Crabtree:

That but if they want to drive new activity, find new customers that don’t know about them, that’s launch capital.

Greg Crabtree:

Mm-hmm (affirmative).

Greg Crabtree:

There’s two techniques, and we go through those in the launch capital chapter of the 2.0 book. We show one technique, where you’re intentionally making this decision and evaluating the results. That’s one where it’s actually a client that allowed us to share their exact data.

Greg Crabtree:

It was a client that grew from 700,000 in revenue and in five years, grew to 10 million. The only catalyst was they increased their marketing spend each year, and then they evaluated the increase in net profit from that increase in marketing spend. Notice, this is one of the weaknesses that you get in the marketing…

Greg Crabtree:

It is.

Greg Crabtree:

Yeah. Yeah, I don’t care how much your revenue went up because you had other ancillary costs that had to be added to support that additional revenue. Those are what we call reflection cost, that they’re an echo of the initial catalytic activity.

Greg Crabtree:

What you’re really trying to get to is what was my net gain, and I want to recover the cost of my investment plus 50% or more on top of that original bet that I made. In the example that was shown in the book, it worked four out of the five years. One year, they just got their money back they missed. They put too much money in and hit that point of the marketplace that says, “You can spend all you want, but we’re not moving anymore because of it. You’ve tapped out the effectiveness level of that marketing spend.

Greg Crabtree:

Mm-hmm (affirmative), right.

Greg Crabtree:

Well, this is a sub-component of that. There’s an overarching return on invested capital that we now use. When I did the original book, I had an observation of profit levels, and I made a statement in the first book and also I restated it in the chapter I wrote for Burns’ book at 5% profit, you’re on life support, 10% you’re good, 15% you’re great, anything above 15%, take it away and get it because the market will compete you back. That works for about 70% of the companies out there, but it was the 30% that I had to do some kind of excuse to say, “Why didn’t that,” work because I had clients that had 3% profit that were nicely profitable, but it’s like why? I kept studying it and fortunately through my EO organization, they let me chair an executive ed program at Horton.

I always say it’s nice that they let a kid from a chicken farm in Alabama hang out with real professors, and I have to give all the credit to David Wessel. He was the one that really turned me on to the idea, and I don’t think even he really knew what I would do with it, because he didn’t have access to the data I had access to. I’ve got access to private companies. All he has access to is a college professor. Even at one of the premier learning institutions, he only has public company data. I got news for everybody out there. There’s a public company, it does things for different reasons than we do in the private real world. That’s why I’m focused on the private business community because you do some crazy stuff when it comes to public stock, but financial concepts are what they are.

I said, “Okay. I had to define what do I think is the minimum standard of return on invested capital for private companies, and I established to me 50% return is the minimum viable standard.” I’ve got a couple of clients below that number, but they can get to 50%. I’ve not modeled a North American company yet that couldn’t get to 50. There’s some that don’t get there just because they’re making bad choices, and it is what it is.

Greg Crabtree:

Invested capital…

Greg Crabtree:

Let’s start with equity, and this was a point that Professor Wessel’s made that I thought was quite clear. He said equity is a flawed calculation, and he’s absolutely right. What you got to do is look at the equity of your business and make a couple of adjustments. Do you have the appropriate amount of cash? I make a big deal about you need two months of operating expenses and cash. If I’m operating at less than full capitalization, I got to take equity and plus it up for how much cash really should be in the business to meet our minimum capital standard.

Greg Crabtree:

Secondly, then you start adjusting plus or minus, do you have any assets that are on your business balance sheet that aren’t necessary for the operation of the business? Fixed asset, related party loan, whatever, intangible assets which really aren’t real. They were just a plug number to buy something. You take all of those things off. If you can’t convert it to value for what it’s stated, you take it off. Same thing on the liability side, you have debt that really is unrelated. Maybe I took on an investment round of mezzanine debt. Well, that was just an investor putting money in for me to take some money off the table, and that really didn’t create any value, it’s just there. To me, I take that out of it. I’m looking at true operating liabilities and accrued expenses and operating debt. There’s a lot of credit, term debt on hard assets, those kind of things. Once I make those adjustments, that number is my invested capital of a existing operating business in that process. Once I get that clean invested capital number, then I look at my net income before taxes because… and to make it universal globally, I want to stick to a number that’s pre-taxed because everybody’s got different taxes…

Greg Crabtree:

Let’s take taxes out of the equation. Let’s say whether I pay taxes on or not, what is the pre-tax return on this asset and that’s what you’re looking for and the explosion…

Greg Crabtree:

Well, it does historically until people focus on it, and what’s amazing is so this has been a passion of mine, is I see people start a really good business that’s building value, and then they get distracted. I mean just imagine an entrepreneur that’s attention deficit. We all are, and we start chasing the shiny object. I kept looking for how can I present the incredible value of what this business is that’s in front of them and get them excited about it as an investment, and that’s why I make a big deal to separate here’s the job that you get and the income that you get off of the thing that you do, but let’s really nurture this business as an investment and stop doing business activity that just provides you a job and let’s do business activity that is a phenomenal leverage to create value.

Alex, if you said, “Hey, I got $100,000 that I’m looking to invest,” I said, “Great. You give me $100,000. What if I give you a 50% return, is that a little better than what the bank or the markets are doing?”.

Greg Crabtree:

Yeah, you give me $100,000 a year from now, I give you a $100,000 back plus $50,000. Oh, by the way, you got to pay tax on that 50,000 because it is taxable, but depending on your tax jurisdiction, you’ve got probably at least 130,000 to reinvest.

Greg Crabtree:

Here’s the dirty honest truth. Fifty percent returns the minimum. Most of our clients operate between 75% and 100%, some as much as 200% return. This is really the explosion of understanding categorizing business operations in terms of understanding a business’s return on investment potential. I’ll give you a great example, probably the best return on invested capital business model we work with is in the IT managed service environment, so MSPs. Those guys if they run their model correctly, so one they’ve got monthly recurring revenue for the fixed services.

Greg Crabtree:

They’ll occasionally bill for projects and activity of those existing customers-

Greg Crabtree:

… but if they do it correctly and get money up front, so that they’re not out of pocket any of that cash, they’re one of the leanest capital structure businesses, because all they need to operate from a capital perspective is their two months of operating cash and a little bit of equipment. Most of them don’t even have equipment. Everything is in the cloud or lease kind of stuff. We run a couple of mastermind groups for MSPs, and the top 25% of those companies in those mastermind groups have a 200% in return on invested capital and so they’re only…

Greg Crabtree:

Their only challenge is to grow.

Greg Crabtree:

Well, see, so their trade capital is zero because they get paid in advance.

Greg Crabtree:

See, that’s what makes…

Greg Crabtree:

Exactly, yeah.

Greg Crabtree:

Yeah, yeah go ahead.

Greg Crabtree:

Right.

Greg Crabtree:

Well, what you’re doing is like I said, you’re one, taking away a barrier to growth. Because when you start to quantify trade capital as a percentage of revenue, so traditional accounts receivable, maybe plus inventory with very little trade support, those businesses 20% of revenue has to be sitting there in trade capital. In those cases, and we make a point of this, we call this the cash power ratio. If your trade capital percentage is at 20% and your profit percentage is at 10%, what it tells you is for every new dollar of revenue growth, I’ve got to put 10% of my money in just to get it started. If I can invert that and make trade capital 10% and profit 20%, I’m 10% positive cash on every new dollar of revenue.

Which business do you think can grow faster, the business that creates positive cash with every new dollar of growth, or a business that has to go get bucketfuls of cash to keep throwing into the company? I’ve got this food distributorclient in Central America that… I mean it’s just dreadful. They have to pay for their inventory when they order it, and they have to wait 60 days to get paid by who they sell to. That’s a bad business model and it’s for you.

Greg Crabtree:

Yes.

Greg Crabtree:

Let me put it to you in a different sense.

Greg Crabtree:

My good friend Alan Miltz, I don’t know if he’s done your podcast, but he’s certainly known in the same community and works with both of us and we both contributed to his book. Alan talks about those components and really, a lot of my thinking in 2.0 came from Alan and I do a lot of joint presentations together. The thing is, is working on those individual components, the answer is yes, but here is the bigger issue. I can’t just focus on AR, I can’t just focus on inventory, I can’t just focus on accounts payable, I can’t just focus on deferred revenue, I can’t just focus on profit. That’s why we put it in relation. I’ve got to look at trade capital as a net number, because there’s trade-offs in.

Greg Crabtree:

There’s things that sit on the asset side-

Greg Crabtree:

… and things that sit on the liability side that can net against each other. I want to give you more tools to say, “Listen, just look at the framework and say if I’m at 20% trade capital and 10% profit, okay, what are my choices? Can I bring down my trade capital?” I mean that’s obviously one of the things, but you may be in a market where, hard as you try, the answer is nope, that’s just the way it is. I’ll share an interesting story within a second about that, though breaking through bad thinking, but then what you have to do is say, “Okay, well let’s shorten the gap, let’s get our profit up.” If I’m handed a trade capital in the 20% range, I just have to get profit up to 15, 17, 18 and narrow that gap.

I will tell you that once people understand both data points, and we’re hammering them with it with every call every month and showing it to them this is the power of data, they start to do things about it. They start to question the status quo, and I’ll give you a good example.

Greg Crabtree:

One of our Australian clients is a staffing business. We have several staffing clients in the US, and staffing businesses are notorious for bad trade capital. Typically, they didn’t have that.

Greg Crabtree:

Yeah, so you’re going to them for either temp services, and they may be specialized in an industry. They may be general…

Greg Crabtree:

Yeah, right. I mean they might do some placement for fee, but it’s mostly you’re renting a body from them for a particular task. Typically, those companies have about 8% to 10% profit, and they have about 20% to 25% trade capital, just dreadful business. I pick up this client in Australia and we start going through his numbers and like, “Hmm, well he’s about 15% profit. Well, that’s good, yeah.” I look at his balance sheet and it’s like it’s a trade capital’s a negative number, so here’s the thing that you want to know. When your trade capital is negative, that means that you’re holding your customer’s money before you do anything. Now, there’s a bad side to that.

You’ve got to make sure that if you’re holding your customer’s money, that you don’t spend it unwisely before you complete what it was that they gave it to you, but if you’re disciplined and do it right, it’s a wonderful place to be. Because in this guy’s case, he had found a way to get his customers to pay him in advance. I said, “These staffing clients in the US, I haven’t seen this in ours. How did you get to a negative trade capital?” He said, “Well, we asked.” “Really, you asked?” He says, “Yeah, I mean the customers we were dealing with, they had the money. We convinced them we were going to do what we said we were going to do, and we just asked for the first month up front as a deposit, and it just stays there throughout the length of the contract.”

Greg Crabtree:

Exactly.

Greg Crabtree:

Anyway, so I get him. I mean they don’t compete, so I get him to talk to a couple of my staffing clients in the US.

Greg Crabtree:

Guess what magically happened? When they were at 25% trade capital and 8% profit, all of a sudden trade capital comes down to 17, profit goes up to 15, gap is closed and all of a sudden, they become magically powerfully cash flow positive.

Greg Crabtree:

You see, they get connected, but not in a direct one-to-one way. You start to see what’s possible. When you see that it is possible to be that profitable, you start questioning all of your decisions of your profit matrix. Am I not charging enough? What’s my direct labor efficiency ratio? In the staffing world, I mean their labor efficiency ratios are really low. You’re looking at about 35 to about 50. Then the next thing, you start to see well if these guys are getting 1.55, why can’t I get that? You start questioning things because you see that somebody actually is doing it, and it’s validated information. It’s not just somebody talking about it in the public. You know that it comes from a validated source of data.

Greg Crabtree:

I will tell you here’s…

Greg Crabtree:

Here’s what I think, here’s what I think causes that.

Greg Crabtree:

When you start to look at trade capital and then you say, “Okay, well here’s my overall trade capital, now let’s look at it…” This is another one of the chapters in the new book. I formed segment P and Ls. When I take the company as a segment and I start looking at it as a line of business and see which lines of business that I’m doing have the best trade capital positions. Then I look at it on a customer basis and say, “Which customers are abusing me on terms, which generally are the least profitable customers,” and I stop doing business with them because I can’t get them there. All of a sudden, I become more profitable because I figured out the picture of what is the type of work that we need to focus on that’s the most profitable and cash flow generating, and what is the type of customer that fits that pattern.

Really, I mean at the end of the day, all we do is pattern recognition. I mean show me an industry, show me a line of business, show me a customer, show me a production unit of an employee or a unit of operation, and see who’s the pattern. Now we’ve got a standard that we can validate and perform to, and it’s not theory, it’s proof. I think that’s really typically what drives up profitability, because I attacked it from another thing to say who are the bad actors.

Greg Crabtree:

We always tell ourselves that.

Greg Crabtree:

Yeah. One of the things that I rail against is the contribution to overhead customers.

Greg Crabtree:

Yeah, I hate that idea because-

Greg Crabtree:

… I’ll give you a good example.

Greg Crabtree:

One of my clients right now is a concrete contractor, and so things got a little slow over the winter for us which is December. They took some contracts at really low pricing to cover overhead, and they didn’t tell me about it until it came up on the next consulting call. Then I go, “I understand you’re thinking, but let’s talk through this.” I said, “Here’s why that was a bad idea, and I mean I hate to tell you. I have to call you out, but I mean it was a bad idea, because you would have been better off just covering those operating costs, because we know that the good work was coming. It’s a known. We weren’t hoping. We knew that the department of transportations that they generally deal with were going to be letting some better contracts.”

It’s like the company was well-capitalized, it wasn’t in any danger. Now because we’ve taken on these low cost deals, it’s getting in the way of now the full margin jobs that are available that we can’t start because we’re still working on this stuff that we took to cover overhead. Client to client to client that takes on those bad jobs, those are the blockers of the high value work. You’ve got to put prioritization on getting those high margin things to the top of the list, but I get it, once you make a commitment, you’ve got to flush out those bad words and mad work and get those out of there.

It’s not to say that you would never do it, but boy, I can’t remember a time when I sit down and work through the math with a client, unless they’re just… I mean if you’re going to start taking on that work, you have to do some other cost mitigation to turn off cost in the business. If you’re not willing to do that, then yeah, yeah just don’t do it.

Greg Crabtree:

Well, and you also teach people bad standards-

Greg Crabtree:

… because yeah… oh, I mean we’re seeing this with COVID right now. We see two dimensionally opposed production outputs from COVID. The companies that kept everybody on staff and had activity drop and they just said, “We had some government PPP funds that you guys may have heard about and all that,” which was great, but all of a sudden with limited work, people settled into a slower workplace. They’re having a really hard time now that their backlog is there. They can’t get back up to the same speed that they were working at pre-COVID.

Greg Crabtree:

Everybody who trimmed to what work they had they’re coming out like a rocket ship. I mean they’re profitable, and they’ve set new productivity standards with… I mean really what we saw and this was… I mean because we got 100 companies, we could look at this. There was about a 10% reduction in direct labor and about a 5% reduction in management labor out of that billion of revenue. Essentially, it goes back to what Jack Welch, the famous CEO of GE used to say is everybody’s got 10 of your labor that really you ought to get rid of right now.

Greg Crabtree:

It’s a harsh statement. Unfortunately, it’s probably true and COVID forced the companies that really looked hard at it. That’s what they did, and they’d never look back and never miss those people. Fortunately, they felt okay, those people actually weren’t harmed too badly, because we’ve had extended unemployment benefits that continue today, that those people are probably doing better not working than some of them did even working. Yeah, that’s going to be a problem.

Greg Crabtree:

Mm-hmm (affirmative), correct.

Greg Crabtree:

Yeah. Essentially, one of the things I always felt like was bad psychology is looking at labor as a fraction of something or as a cost. Realistically, I mean you guys tell me, but I don’t see anything productive in the world happening without labor. Until we were totally inundated with artificial intelligence, it takes humans to make things happen of value.

Greg Crabtree:

In the first book, I used a simplistic measure, which is a good way for people to think about it, and part of this was driven by my disdain of this calculation that I think I make a point somewhere in my… I did an article, I don’t think I said it in the first book, but it said never ever, ever represent your company as revenue per employee. I mean I just hate that discussion because one, revenue is the most flawed number on your P and L. None of us have the same revenue quality of a dollar of revenue. Now once you take revenue minus cost of goods, gross margin across all those businesses is a comparable number, but not labor.

Everybody deploys labor at a different output rate, and I use this as a way to teach it is if I’m in a staffing business, I’m generally producing gross margin because I really don’t have any COGs, but I’m gross margin of about one and a half times what I’m paying that person. What that means from… it’s a measure of how much the marketplace respects the value of your labor if you want to look at it in a harsh way of saying for every dollar that I’m spending on labor, the market’s willing to give me 50 cents extra, which 10 cents of that 50 is for payroll taxes and minimum essential benefits, and 40 cents is for me finding the person, getting them to show up, and replacing them if you don’t like them.

Greg Crabtree:

Gross margin-

Greg Crabtree:

… divided by gross wages of that person that you’re charging out. That is the low end of the value scale. I always use staffing as the low end. Generally, and this is a lot I think the data point is a little bit of what I call pricing bias is if you do the cost build up equation, you’re going to see a common data point of gross margin per labor dollar at the $2 level, because that’s really the cost recovery of a decent profit. If you do what you say you’re going to do, that’s about where the number always comes out to, but if you’re really good at billing for the value and having true IP value, know-how, those kinds of things, then you can move upscale.

Our IT managed service clients, they’re probably an overall labor efficient county management and direct in that 220 range to maybe 220 to 250, but their direct labor, one of the things we do in the new book…

Greg Crabtree:

Right, right.

Greg Crabtree:

Exactly.

Greg Crabtree:

Yeah, that simplistic measure is that hundred thousand salaries is a blend of everybody in the business, and so…

Greg Crabtree:

Yeah, right. In the advanced way of looking at it, we go into a whole chapter of splitting it between direct labor and management labor. Direct labor, it’s still looking at that gross margin number, but because it’s only direct labor, you get a much finer analysis of how you make money. In the professional services world that I live in, my direct labor efficiency ratio is going to be a two in most of those businesses, and a landscaping business is going to be a four. Here’s the reason why those two things exist. In a professional services world, you’re lightly managed. I’m expected to be a professional and manage myself. I’ve got a much lower cost of management labor overseeing that professional labor.

In a lower labor cost category that needs direction and guidance, I’ve got a much more expensive management structure to get that 4$ value. What we see is it helps businesses as we go through these analyses and examples, we see businesses… like we get a lot of data points in the managed service provider world, where we see they should be a four direct LER and they should be a forward management LER. In that environment, we see a 250 direct labor efficiency company, but we see a seven on the management label. What that’s telling you is I’ve got very inefficient direct labor, because I didn’t hire enough managers to make them productive and I’m trying to run them almost more like a professional service.

We get them to say, “Hey, you’re not giving your people enough guidance and coordination. You’re leaving it too randomly up to their choice, and that’s not the most efficient output business model. You got to invest in management labor. The more common…

Greg Crabtree:

Yeah, that’s manage…

Greg Crabtree:

I started off calling it admin labor-

Greg Crabtree:

… and I got pushback from my managers… the management people got offended that I called them admin. I said, “Okay, we’ll just call the whole bucket management labor.” It is anybody who’s not direct is management labor.

Greg Crabtree:

Direct is to gross margin. Management labor is to what we call contribution margins, so it’s gross margin minus the direct labor. We move one more step down to hold management accountable to that number in that process-

Greg Crabtree:

… and because ultimately as a manager, you have three variables, your responsibility and that if you’re not a direct labor person, your responsibility is to help increase revenue, minimize cost of goods sold waste, and make labor efficient. I can affect that contribution margin from any of those three elements. Typically, what we see managers tend to be overly focused one to the detriment of the other two. We wanted a measure that says, “Listen, I don’t care how you get there. You can run all kinds of plays you want, but just making a dollar drip out to justify your existence is what you have to look at.” Once you…

Greg Crabtree:

Yeah, exactly and we say that contribution margin to me is the most important number on the P and L, hands down.

Greg Crabtree:

That is that reduction-

Greg Crabtree:

… of a dollar of contribution margin, because that’s the pure horsepower of the business engine, that is the output.

Greg Crabtree:

Revenue, well the COGs.

Greg Crabtree:

Yeah, cost of savings.

Greg Crabtree:

Minus direct labor.

Greg Crabtree:

You have to take out COGs first.

Greg Crabtree:

Well, but you can have cost…

Greg Crabtree:

Just because I have services doesn’t mean I don’t have cost of sales, or you can call it cost of goods or cost of sales. It’s an interchangeable term. There are things that I choose to pass through. Here’s the thing that you got to look at today’s businesses.

Greg Crabtree:

We have basically deconstructed business to say focus on the one piece of a value chain that you really do well. Why is it that a general contractor is a general contractor? Why don’t they do framing? Why don’t they pour foundations? Well, now they get a subcontractor to do it. Well, that subcontractor is a blend of two things; materials and labor, but there again, I am taking now that that subcontractor is a business unto themselves and they have to be profitable to be sustainable. What I’m choosing to do as a general contractor is take the value chain of building a building and saying, “I really just want to be paid for the coordination of all of the things that happen, and you’re paying me for the value of what I do and I still make a profit off of my cost.

These other people are being paid for the value of what they do, and they’ll make some profit too. We’ve all shared that in the overall value chain, but it’s not unheard of that I could create a company that knows how to pour concrete and put framing and put roofs on and do carpet installation. It’s not that it can’t be done, but the business community has said, “Well, you can’t be really good at all those things.” Good example, I use this one all the time, it’s like if you’re a manufacturer. Well, you’re a manufacturer, I got news for you, you’re also a sales organization. The question is can you be world class at manufacturing and sales? Probably not. Well, maybe I’m good at selling stuff and I need to do contract manufacturing.

Why is it that we have stuff made in China and Latin America or just by somebody else even inside your own country? Because they can make it faster, better, cheaper than I can. I conceptually designed the product that I needed, but maybe I don’t like doing that. I may be really good at making stuff, and I suck at selling it. Well, that’s why distributors exist in the world.

Greg Crabtree:

Exactly.

Greg Crabtree:

Exactly. Here’s a great framework that I use all the time in our consulting class, and I learned this from one of my clients, a company called Quickparts.com that I helped them get started. They had a great arc sold out in about 10 years and learned a lot from the CEO, Ron Hollis and I got to be really good friends, but Ron, this company, they were the first ones to create an instant quote for a custom manufactured park. If you were a product designer and a CAD program to design the part, you would upload this output file from the CAD program and you get an instant binding quote for a prototype of this mouse the next day.

Greg Crabtree:

Incredible, this was in the year 2000. The thing was Quickparts didn’t own any equipment, they didn’t make anything. What they did was is they had a pricing algorithm that said there’s a thousand or more data points out of that STL file, but there were only 14 that mattered for pricing, which is a very important point. They tested this algorithm of pricing. They hired a supplier that tested the algorithm and said, “We will make any part that you quote under this pricing algorithm for 60% of whatever you’re quoted for.” That establishes a benchmark that we use frequently of saying in the value chain of a product or service, 60% of it is the value of doing it, but there’s 40% that has three components to it; the marketing of it, the sales and closing of it, and the oversight of it.

What Quickparts built a business around was not owning a single stitch of prototype equipment. They got 40% of everything they sold, but they had to market to the marketplace. We think of that 40%, 20% of it’s the marketing value, 10% of it is getting to contract, 10% of it is the oversight and coordination with a customer to make sure that things flow smoothly, and they get what they’re looking for. You can add plus or minus 5% to each of those four components of marketing, sales, oversight, production, but at the end of the day, it’s an incredible framework for the separation of an economic activity into… you could have four distinct businesses doing each of those elements, and many of the people doing business today are exactly that.

They are one of those four components, and then that’s their business. You have to stay true to say, “Am I getting the appropriate value? Am I being overcompensated for a temporary period of time and the market eventually wakes up and realizes I’m an unnecessary component at that price?”

Greg Crabtree:

Those are harsh things.

Greg Crabtree:

Oh, yeah.

Greg Crabtree:

Yeah.

Greg Crabtree:

Yeah, exactly. Let me give you examples. We had a client that’s an Amazon reseller. They were doing about 55 million in revenue, losing about two and a half million at the time. I was worried that I was going to wind down the business, but we got into it and they were selling 33,000 SKUs. I mean they had a lot of product. We did a quartile analysis looking at these elements of I’m looking at margin by product, and I’m looking at terms by product. Those terms, think of terms on a per product because this company didn’t have anything of their own.

They were just reselling other people’s stuff. With each one of their vendors, there was a speed of inventory turn, as well as then what are the terms I get from the supplier; who makes me pay them in 30 days, who makes me pay up front, who gives me 60 day terms. This is why trade capital matters because it is a net number. If I got slow moving inventory, I don’t care as long as I got longer terms.

Greg Crabtree:

If I have fast moving inventory, I can live with shorter terms, but it’s the net of the…

Greg Crabtree:

Yeah.

Greg Crabtree:

When I’m interfacing, customers and vendors all have different needs. I just have to look for where is my op… if my opportunity is not on the customer side, then I have to go after the vendor side, and make that vendor a partner almost in that regard, but if I can convince them that I can triple or 10X their activity if they’ll work with me, I’ve got a more valid argument with them to give me some support. I’m not doing it just because I’ve got power over them. I’m doing it in this win-win approach, which is my favorite approach in business.

Greg Crabtree:

Yeah. When you can craft those decisions that way, you can get people to move off of a hard position. Anyway, we went through all 33,000 SKUs and we said we came back and said, “Well, we got some good news we got some bad. The bad news is you need to stop selling 32,000 of the 33,000 SKUs. The good news is if you focus on just the thousand that are best, you’re going to drop the 35 million in revenue which at the end of the day who cares, but you’ll make 750 of profit,” and that’s exactly what they did. Part of it was that we found a couple of flaws in there.

They had created some artificial intelligence on reordering quantities, which you always got to be careful of validating when you put some AI in place that we found some of that issue, but essentially, we help them form an analysis framework of every vendor relationship. Because when it comes to product, the key is speed of margin. I need a minimum quantity of margin, but I also needed to move quickly through the equation. Pre-COVID, I did a speaking tour in the Middle East, and I was in several UAE areas. I was talking to them about their businesses and they said, “Well, you know, the government’s really promoting entrepreneurism, but the government was the key offender.”

I mean these guys could be profitable, but they were having to wait 120 days if they did business with the government to get paid.

Greg Crabtree:

Actually, I think… was going to actually have to come back and talk to their finance ministry to say, “Listen, if you want to spur entrepreneurism, I got a simple answer for you. Just be an exemplary payer…”

Greg Crabtree:

Pay faster.

Greg Crabtree:

You’re going to pay it, you have the money.

Greg Crabtree:

I will tell you, I’ve come to this very harsh conclusion. If you want to be a third world economy, just slow down the payment of things. If you want to be a first world economy, just make margin flow fast through the economy.

Greg Crabtree:

Because when I went to Kenya, there is no lack of demand in Kenya. It’s just it’s a dysfunction of terms of how fast cash flows to the system-

Greg Crabtree:

… and here’s what happens, when you have slow moving cash in a system or a marketplace, only the big boys can play because they’ve got capital and see, this is what has opened up like the US… I mean cash is not a problem. Execution is our only problem of creating successful growing businesses in the US.

Greg Crabtree:

Now that starts to separate the herd a good bit because there’s those who can’t execute–

Greg Crabtree:

Yeah, but it’s a wide open race. I think Australia from my clients that I talked to down there, I mean I think you guys are pretty much in that same mode. Matter of fact, like I said in the staffing business, my client there had better payment structures than our clients in the US.

Greg Crabtree:

See, here’s my hope. I honestly think it’s just we just don’t know how to talk about it, and we’ve been operating under this philosophy that’s in the 2.0 book for about four or five years now, but much more so in the last three I would say. What I’m seeing is we’ve seen more success of people transforming their business into a high return on investment business, where the 20 years previous it lacked.

Greg Crabtree:

Yeah, yeah.

Greg Crabtree:

There’s math.

Greg Crabtree:

Yeah.

Greg Crabtree:

Well, the good news is…

Greg Crabtree:

Yeah, I’ll give you some inside baseball knowledge here that last month I went in the studio and finally recorded the audio version of the first book, so that actually will be coming out here-

Greg Crabtree:

… probably in the next month or two.

Greg Crabtree:

Then in a couple of weeks, I actually go back to record the second book, so we’ll have both of them out in audio format…

Greg Crabtree:

Yeah, it’s coming, it’s coming.

Greg Crabtree:

What’s been fun is… yeah, the first book I would say is definitely that aimed at the 5 million and under business, because I’m trying to break through some bad ideas, but we’ve actually found even $20 and $30 million businesses that found the things I talked about useful. The second book really to me is knows no beginning and end in terms of scale. We’ve actually found a lot of our much larger businesses, especially in the ones we do a lot of segment work with a lot of the bigger businesses. Because let’s face it, if you’re a $20 million business, you’re probably $4 or $5 million unit, something that they may have different values because we just did a finished project with a $20 million HVAC client.

They had eight divisions and just totally blew them away. I mean they have a really high level controller. I mean they have really good data, but they didn’t see the direct labor efficiency ratio was the first thing that really jumped out at them by division, because some of the things that they were scaling were the things that had the lowest leverage of labor. It’s like, “Listen guys, this isn’t where the gold is. This division over here, this is the one that’s got the bigger, better leverage factor to it.”

Then when we apply the cash flow terms to each of those, oh man, when you start looking… one of the things when I’m doing segment accounting is I look at contribution margin dollar per trade capital dollar invested and boy, you want to talk about an eye opener when you start to see here’s the true operating cash flow that I generate from the trade capital invested, and here’s the one they had a parts division. They were basically paying for the parts division. I mean it was just awful, but once you see the data, you start to ask different questions.

Greg Crabtree:

Yep.

Greg Crabtree:

Sure, sure.

Greg Crabtree:

Yeah, the best thing there’s a contact page on the simplenumbers.me website that you can reach out. Like I said, we have clients in Australia so we work across all timezones. There’s a timezone that fits. Typically, we’ve either done for us either super early in the morning or late in the evening. We don’t mind that. I mean that’s just not…

Greg Crabtree:

Yeah, exactly.

Greg Crabtree:

Yeah, these are our staff. I mean it’s really cool that it’s something that I… whereas our firm really doesn’t think about things globally. They’re focused pretty much from North Carolina to New Mexico footprint, but ours is we still do what we do globally, as well as some of the other units. Really to me, I’ve always looked at it as a way to challenge my thinking to validate it and say, “Hey, you see different parts of the world operate slightly differently, but at the end of the day, entrepreneurism is entrepreneurism. I do have plans to get a book tour and go through Australia and New Zealand hopefully next year. Targeting for March of 22 that I can get down and do a long-awaited tour in the region.

Greg Crabtree:

That’ll be fun.

Greg Crabtree:

I’ve been to Sydney and Melbourne before, but we’d love to get back and see the country coast to coast.

Greg Crabtree:

Any time.

Greg Crabtree:

Yeah, good day, appreciate it.