A payroll that exceeds 30% of gross revenue is one of the most common reasons businesses fail.
Deciding how much of your revenue to allocate to employee salaries is a critical consideration to make. Payroll is frequently one of the most significant expenditures for a business owner. Not only is payroll regularly occurring, but it also comes with additional considerations: taxes, insurance, and add-ons like vacation time, sick days and other benefits. For managers trying to hold on to already-slim margins, payroll is frequently the expense item that can make or break a business.
Less Isn’t Always Better
Frequently businesses that have unsupportable debt look to reduce payroll in order to improve cash flow. This fairly common practice may be counterproductive, however. For instance, decreasing staff too severely can have the effect of overburdening remaining employees, thereby impacting morale and quality of work. With your business purpose and goals in mind, balance is the more appropriate objective.
Unfortunately, there is no one magic payroll equation that can be applied to every business. When considering your degree of profitability, taking gross revenue and industry standards into account along with other business functions can aid you in determining what percentage of revenue should be spent on payroll for your business.
Start with the Industry Standard
Service businesses—for which payroll is the major cost of providing the service—have higher payroll percentages. These businesses see diminished costs in other areas, so payroll can reach as high as the 50% mark without destroying profitability. Manufacturers, however, must maintain a payroll figure closer to 30% or less, as the business must endure the cost of manufacturing the widget in addition to the payroll. The same goes for restaurants; given the high cost of food, the payroll must stay under the 30% benchmark.
Publications that specialize in your industry are a good place to search for statistics on what percentage of revenue should be spent on payroll. Plug these numbers into our cash flow pro forma spreadsheet to view a data-based approach to managing your numbers that will help you to be profitable.
Many business owners fail to include themselves in the payroll equation and, therefore, report payroll numbers that are deceivingly low. Regardless of whether owners take a traditional paycheck or qualify their income as “owner’s draw,” it should be included in any payroll calculations to provide an accurate picture of your finances.
Measure Your Employees’ Productivity
The most important number of all is the degree of productivity your employees give your business every hour, day and week. This number is measured by taking the total output and dividing it by the total input. If your company makes $60,000 in goods and services in 1200 hours, then the total productivity is
$60,000 = 50
meaning that your company generates $50 of income per hour of work. If you can calculate this number using each of your employees’ individual outputs, you can see just how valuable each’s contribution is to your bottom line. Even if you aren’t able to do this down to the granular level of each individual employee, knowing this number for your entire staff as a whole, and setting a benchmark to which you’d like to raise it, can help guide your management efforts. Putting incentive programs in place is one way to increase employee productivity and business profitability.
Knowing what percentage of revenue should be spent on payroll for your specific business is the first step toward profitability. The larger issue is what to do with that number.
Second Wind Consultants has worked with hundreds of business owners to identify Key Performance Indicators (KPIs) that will give you a birds-eye-view of where your cash flow is allocated. If we identify an area of concern, we’ll help you develop strategies for making payroll reductions and guide you toward balance.
We call this “management by the numbers” and it’s crucial for putting you in the driver’s seat toward prosperity. Remember, it’s about more than simply evaluating how much your payroll costs, and then cutting staff where necessary. The productivity of your employees in tandem with how your management implements incentives and meets performance metrics all play a critical role in increasing your revenue in the long term.
Need assistance reducing your payroll costs? Contact us today for a free consultation. Our management consulting services will set you on the path to business success.