Empowering Healthy Business: The Podcast for Small Business Owners

#17 - Can You Afford to Hire an Employee?

June 11, 2024 Cal Wilder Episode 17
#17 - Can You Afford to Hire an Employee?
Empowering Healthy Business: The Podcast for Small Business Owners
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Empowering Healthy Business: The Podcast for Small Business Owners
#17 - Can You Afford to Hire an Employee?
Jun 11, 2024 Episode 17
Cal Wilder

Healthy businesses have an established business model in which most new incremental hires produce profit for the business. Payroll expense can be viewed as an investment that yields a profitable ROI. Usually a hiring decision boils down to a question of how much more revenue do you need to sell in order to afford a new hire. This episode helps answer the question of whether you can afford to hire an employee.

More specifically, this episode includes:

  • Viewing Employees as Profit Centers
  • Return on Investment vs Affording a Hire
  • How Much Do You Need to Sell to Afford a Hire?
  • How Much Does a Salesperson Need to Sell to Pay for Themself?
  • How Much Must the Business Grow to Hire a Manager?
  • Labor Value Multiple
  • Forecasting; Fixed & Variable Costs

Download the employee Hiring ROI Workbook using this link

Sponsored by SmartBooks. To schedule a free consultation, visit smartbooks.com.

Thanks for listening!

Host Cal Wilder can be reached at:

Show Notes Transcript Chapter Markers

Healthy businesses have an established business model in which most new incremental hires produce profit for the business. Payroll expense can be viewed as an investment that yields a profitable ROI. Usually a hiring decision boils down to a question of how much more revenue do you need to sell in order to afford a new hire. This episode helps answer the question of whether you can afford to hire an employee.

More specifically, this episode includes:

  • Viewing Employees as Profit Centers
  • Return on Investment vs Affording a Hire
  • How Much Do You Need to Sell to Afford a Hire?
  • How Much Does a Salesperson Need to Sell to Pay for Themself?
  • How Much Must the Business Grow to Hire a Manager?
  • Labor Value Multiple
  • Forecasting; Fixed & Variable Costs

Download the employee Hiring ROI Workbook using this link

Sponsored by SmartBooks. To schedule a free consultation, visit smartbooks.com.

Thanks for listening!

Host Cal Wilder can be reached at:

Moderator  00:01
Welcome to the Empowering Healthy Business podcast, THE podcast for small business owners. Your host, Cal Wilder, has built and sold businesses of his own and he has helped hundreds of other small businesses. Whether it is improving sales, profitability and cash flow; building a sustainable, scalable and saleable business; reducing your stress level, achieving work life balance, or improving physical and emotional fitness, Cal and his guests are here to help you run a healthier business, and in turn, have a healthier life. 

Cal Wilder  00:35
Welcome. Joining me today is Lindsay Jarosch, Director of Cloud Accounting at SmartBooks. Good morning, Lindsey. 

Lindsay Jarosch  00:42
Morning Cal.

Cal Wilder  00:45
So when we're working with clients, one of the questions we regularly are asked is "Can I afford to hire an employee?" You get that question sometimes right?

Lindsay Jarosch  00:55
All the time. That's one of the most popular questions I think we get from our clients here at SmartBooks.

Cal Wilder  01:02
So let's think about why businesses have employees. It might seem obvious, you need employees to do work. But ultimately, that work should help generate profit for the business. Payroll might seem like an operating expense, but let's think of it in terms of return on investment. In big businesses that can be that can be really hard to measure. For example, if you are one out of 1,000 or 10,000 employees at a big company like Home Depot, or maybe you worked at Twitter, before Elon Musk purchased the company and laid off a bunch of employees that he didn't think were producing ROI, you know, you might not really have a good sense for how to measure return on investment of hiring another employee in a company that size. But in small businesses, which is really the focus of this podcast, it is a lot easier, there's really nowhere to hide. In a lot of small businesses, every employee in a small business must contribute. And it's usually pretty clear whether they're contributing and at least generally, you know, how much they are contributing, right?

Lindsay Jarosch  02:08
Yeah, definitely. And often in small businesses, employees are the first to speak up when they're too busy or overworked. And that's when you hear that they want to hire another person. So we hear business owners coming to us say "My people are too busy, you know, we need more capacity." Sometimes even business owners will have a business coach that says they need to hire a salesperson in order to grow the business. So there's a lot of reasons why business owners may need to hire another employee. Sometimes business owners want more time for themselves. So they say I'd like to hire someone to manage operations or hire somebody to manage a particular department in the business.

Cal Wilder  02:57
And so we can dig into a lot of the details of how to assess whether you can afford to hire an employee. But you know, the first thing we want to do, before we post the job ad and start the recruiting process, is really to assess the current financial situation of the business. If we think back to the financial operating system, step one is to get clear on what you're trying to accomplish financially in owning the business. You know, what are we aiming for financially. And then we can consider hiring decisions in light of that objective. And then step two of the financial operating system is to assess your current financial performance. So are we in a position to afford the hire, and how can we financially justify making that hire? 

Cal Wilder  03:44
I almost think the better way to phrase the question is not so much can I afford to make a hire, but rather, how do I get a return on investment on this hire? Because you could have cash in the bank, you could have access to a line of credit, you could have nice operating profit margins. In those cases, you could certainly afford to make a hire. But just because you can afford to make that hire doesn't necessarily mean you shouldn't go ahead and do it and make the hire. So the question is not so much can you afford it. The question is, how are you going to get a return on investment? And unless we can answer that ROI question, then we're taking a risk that we're going to spend that cash down or our profit margins. Worst case, maybe we borrow money to make a hire that really does not make a positive net financial contribution to the business right?

Lindsay Jarosch  04:36
That's right. And often you know, if your people are too busy and they're working at capacity and you decide it looks like you need to hire, generally your your revenue is up, your profit should be very high, you usually have some cash in the bank. If that's not the case, and margins are low, but people seem to be very busy, then there's usually a problem. It's usually something to do with pricing, maybe billable utilization, price realization, overhead rates, you have to dig in a little bit and really understand, why is it that people seem to be so busy yet, you don't seem to have the ability to hire a new employee. So sometimes you have to do some serious FP&A to solve the current profit problem before you can add another employee to help everyone or give everyone a little bit of relief. But if margins are high, and you have new customers in the sales pipeline, and you're confident you'll you're confident that you're going to have sales down the road, then you might not need to do all that FP&A, it's obvious that you should hire another employee and hire somebody whose job it is to deliver revenue generating activities. And you'll be all set.

Cal Wilder  05:58
Yeah, if you're considering another kind of hire somebody who's not actually doing the work to deliver the revenue to customers, if you're considering a hire like a salesperson or a manager of some kind, then we usually need to do a little more involved financial analysis or FP&A, as you put it, financial planning and analysis. We really need to understand the economics of the business and the cost structure of the different departments things like, you know, what are the fixed costs of the business that are not going to change if we hire an employee, or we sell more revenue, or variable costs that will go up and down based on changes in revenue? And what are the resulting profit margins. And we'll look at some examples in a few minutes. But, you know, we need to make sure we've got a chart of accounts laid out with payroll segmented by departments, so we know how much it's costing to deliver or produce the goods or services, how much we're spending on marketing and sales to bring in the business, what our G&A overhead rate is, right? So we need some clean accounting and a nice reporting foundation we can use to do that analysis around making those kinds of hires. If we're operating a little bit blind, and we don't really know the financial performance of the business and, how that will change based on adding another salary to the business, then we're kind of operating on gut feeling. And that can be a recipe for losing money, especially if we're talking about people who are not directly revenue generating, right. And so we see a few different hiring situations. e may be looking at a business that's smaller and growing, where it might be the first employee that's hired by the owner, after founding the business. Or it could be an incremental hire for an existing role, we need one more person to add to the team that does X, Y, or Z. Or it could be a new role, it could be a manager, or it could be some kind of a sales and marketing role that that doesn't currently exist. How do we model out the financials of adding a new kind of position in the business? And then, you know, sometimes it could be an assistant to the founder CEO. And then in all of these situations, we can measure and figure out how to manage toward achieving a return on investment. You know, sometimes if the founders hiring an assistant, you know, that's not necessarily a direct ROI, but in that situation, the owner is kind of trading personal income for personal time, and that might be okay, too. 

Cal Wilder  08:36
One important question we've got to answer when we're thinking about making a new hire to the business, if it's going to increase the headcount of the business, we need to sometimes answer the question of how much more do we need to sell? How much more revenue do we need in order to pay for that hire? And to take it a step further, how much revenue do we really need to sell in order to make a nice profit on that hire, after we're able to cover the costs of the hire? So to answer that question, we've got to look at the cost structure and the profit margins of the business. 

Cal Wilder  09:13
Say you want to make a hire that has a salary of $75,000 a year. So the first thing to realize is the actual cost of that hire is a lot more than $75,000. There's payroll tax, there's usually employee benefits, there's training, there's IT expense, there's office space, they probably have some expense reimbursements, right. So that $75,000 of salary could easily be more like $100,000 of expense. So understand what the the loaded cost, so to speak, of the of the position is...

Lindsay Jarosch  09:51
...Even costs like training the new employee, add to what it costs to bring an employee in the door so it's not just the wages and the benefits and everything like that. Hiring an employee is expensive, right?

Cal Wilder  10:07
So Lindsay, let's say I think, okay, I got a position here, I figured out, it's really gonna cost me about $100,000 of loaded cost. Is it as simple as just go out and sell $100,000 of more revenue?

Lindsay Jarosch  10:23
You might think we need to sell $100,000 more to pay for the new hire. But is all that 100k of incremental revenue really available to pay for the higher... consider like Cost of Goods Sold, gross profit margin, if you're 100% a professional services business with no third party costs that you resell or bundle into your service offering. There's no more marketing or G&A overhead costs incurred to employ one more employee, then maybe the full 100k is available to pay for that employee. If you think of a law firm, for example, with owners and partners who do all the business development and sales, their product is billable hours, they don't resell products or third party services, they don't have much, if any client acquisition costs. And the partners are doing the selling through personal relationships. In that case, hiring one more attorney may not have much incremental cost to the firm beyond the direct cost of that attorney. Of course, you need more than $100k so there's profit leftover. So maybe you want 125k to get a 20% offering or operating profit margin in that case.

Cal Wilder  11:48
So it's it's simpler if we're talking about a straight professional services business, like that law firm example. But many businesses are not pure professional service, business models, right? Look at a marketing agency, for example, they may resell Google AdWords or Facebook ads to their clients along with their services. Or it could be an IT managed service provider that bundles in some software licensing and maybe some computer hardware as part of their monthly service package, or they implemented as part of a project for their customers, right. And so if they sell a new customer, or $100,000 of annual revenue, maybe $30,000 of that is cost of goods sold that needs to get paid to a third party, you know, the marketing agencies paying it to Google or Facebook or the it MSPs, paying it to Microsoft or in your micro or their other suppliers. So that $100,000 really only nets $70,000 of gross profit. And it's really only $70,000 that they have to spend on their internal operating expenses of the business. And then, you know, many businesses have marketing costs and sales commissions to pay as part of bringing in new customers. So let's say you want to hire a new service delivery person who's going to deliver you know, IT services to your customers, if you're an IT MSP, so they get paid out of that gross profit. So they get paid out of that $70,000 In the example. But is it really $70,000 that's available to pay that person. If you've got a salesperson, then there's probably some cost of customer acquisition. Or if you've got marketing campaigns that you're paying for to bring in new leads, then you might be paying something like 10% of the new revenue in order to acquire and bring on that new customer. So if the customer is paying $100,000 a year in revenue, it may cost you $10,000 to bring on that customer. To market and sell to them right? So we've got to subtract that out of the gross profit. And then we can see how much money is left over to pay for that hire. And so we really maybe only have $60,000 left over to pay for the new service person after both cost of goods sold is factored in as well as the cost of customer acquisition. So it's really critical to consider the fixed cost and the variable costs that get associated with you know, incremental sales and you know, incremental growth in revenue. So Lindsay, we created a workbook here that we can use to help analyze these different cases that we're going to walk through. The workbook is available to download using a link in the show notes at EmpoweringHealthyBusiness.com. And I think if you're listening to this podcast, you're going to get a lot more out of the rest of the episode if you download that workbook and reference it as we walk through the different cases. 

Cal Wilder  14:47
So let's look at our workbook here. We look at the base case on the left. This is a business that happens to have a nice round number of $1 million of total revenue. In our example, they spend 30% of that on third party Cost of Goods Sold in this business. So that leaves them $700,000 of gross profit or 70% of revenue. If we keep going down the income statement, they spend 30% of revenue on people who go deliver the service. So it could be that technicians in an MSP, it could be the website designers and SEO managers in a marketing agency, whatever it is they're doing for their clients, you know, they're spending 30% of revenue on doing that work. So that nets them a $400,000 contribution margin. We call it contribution margin in the way we structure the Chart of Accounts and the income statement and do our financial analysis in QuickBooks. QuickBooks doesn't know the difference between third party cost of goods sold and your cost of payroll service costs, if you've got them up as a cost of goods sold type GL account. So QuickBooks may report as gross profit what we are calling contribution margin. But when we're doing the analysis, it's important to separate out those cost of goods sold to get paid to third parties. Because that's not money that you have to spend on your own business, that's money that's going straight out the door to a third party. And then the cost of actually doing the service, manufacturing the widgets, whatever it is, the cost of people doing the work that deliver the revenue. So those all net out in the contribution margin. And in our example, that's 40% of revenue, or $400,000. Now, the contribution margin is what's available to pay for marketing and sales to bring in new customers, and our general and administrative cost, our overhead to operate and manage the business.

Cal Wilder  16:47
So in our example, we're spending the 10% of revenue on customer acquisition. And we're spending 20% of revenue on G&A overhead. So SG&A, so to speak, is about 30% of revenue. So if we net out the 30% of sales in general and admin costs, from our contribution margin, it leaves us $100,000 or 10% of revenue as bottom line, operating profit, right. So that's the base case we're working with. And now we're going to try to answer the question, if I want to make a higher, and I'm confident I can sell $100,000 of new revenue this month or this quarter, how much of that $100,000 is available to pay for that new service higher. And so here's where we're going to apply some fixed and variable costs and see how much of that $100,000 of new sales revenue were able to drop to the bottom line is incremental operating profit that could be used to pay for a new hire. 

Cal Wilder  17:49
So we got an extra $100,000 of revenue, and we still have our 30% Cost of Goods Sold. So that nets us $70,000 of gross profit. Now, we haven't hired that new person yet. So we don't have any change to cost of service yet. So that nets an extra $70,000 of contribution margin. Now we had to pay our 10% of the new revenue to go and acquire that revenue. So that nets us out $60,000 of incremental margin. So of the $100,000 that we expect to sell, only $60,000 of that is available to pay for that new service fulfillment hire. So we can iterate here, we can say, if my new hire has a loaded cost of $100,000. You know, what does that top line incremental revenue need to be in order to drop $100,000 I mean, incremental margin. So I think it ends up being about $167,000 of new revenue that we need to sell in order to drop $100,000 of incremental margin that we can then invest in paying for that new hire. Of course, we don't want to just break even on the new hire, we want to make a profit, we want to get an actual positive return on investment. So if we're just paying for the new hire, we're getting a 0% return on investment. So you probably want to be selling at least an extra $200,000 or something like that of incremental revenue in order to yield a profit on the new hire. So Lindsay, let's look at another case here. You know, our workbook here in Case 2 where you want to hire a salesperson to try to grow the business. What does that look like?

Lindsay Jarosch  19:32
Yeah, so when you want to hire a sales person, the question that you're trying to ask in this case is how much new revenue does a sales hire need to sell to pay for themselves? And some of the things that you have to think about with a sales hire is it takes time for a sales hire to ramp up and a large percentage of sales hires are not successful, unfortunately need to be fired or let go. The other thing was salespeople as they take expect the company to spend more money on marketing to generate leads for them to sell. So often you need to set tight that targets a little higher than the bare minimum needed to pay for just that sales hire. So some things to think about. But if we look at this case, looking at hiring a new salesperson, the incremental revenue, for example, 250,000, which is really sort of what you're trying to get at, like, what do I need to cover this sales hire. So in this case, the sales higher, you can see the cost of service goes up 75,000. With the incremental sales, you know, the gross profit will be up, you can see as a percent of revenue, gross profit is 70%, which actually is the same, you really see the difference in adding that cost of service line item for the salesperson. So contribution margin is at 40%, with that additional salesperson. And so you can see the incremental margin at the bottom is 100,000, which is 40% of revenue. So really, when I look at this step, I really try to back into it often I'll look at, you know, what do we want the bottom line number to be, and add in the additional costs that come with adding a salesperson to get back to that incremental revenue that need that you need to have to cover that salesperson? And in this instance, the answer is you need 250,000 of incremental revenue to really cover and make this salesperson worth it.

Cal Wilder  21:41
So if the salesperson has a loaded cost of $100,000, they need to sell a bare minimum of an extra $250,000 to pay for themselves. And we really need more than that, to turn a profit on the on the higher.

Cal Wilder  21:58
 All right, let's look at case three. So this would be hiring a manager to manage something in the business for you. So the question here is, you know, as we keep talking about how much more revenue do we need to sell in order to pay for this manager hire? So the answer is a lot, because managers don't directly sell most of the time, and they don't directly deliver revenue to customers most of the time. So usually, there's a pretty dramatic growth required in the business in order to justify hiring a new manager position. So in case three here, you know, let's say the manager has a loaded cost of $150,000. Right. And so that's going to appear in the general and administrative overhead part of the chart of accounts. But so we got $150,000 Manager cost. And if we sell incremental revenue, we're going to have to spend 30% of that on third party cost of goods sold, and we're going to have our internal cost of service, which will be 30% of revenue. So using the same cost structure on the incremental revenue, we're going to yield an extra $150,000 of margin if we sell an extra $500,000 of incremental revenue, right. And so remember, the base case was $1 million of annual revenue, we want to hire a manager with a loaded cost of $150,000. So we need to, we need to grow this business 50% pretty quickly, in order to justify hiring this manager. So if we have a lot of confidence in our sales pipeline and the ability of marketing to generate new leads and really add 50% to the top line, we could justify hiring this manager position. But we might not be able to do that. Manager hires tend to be step functions, meaning, you know, it's hard to get 1/3 of a manager, right? You can outsource fractional consultants. And that's a great way to solve some of your needs in certain situations. Like if you need a CFO for a few hours a week, you're not going to go hire a full time CFO in a small business. So you can solve that problem with a fractional CFO, which is a whole industry to itself these days. But if you need somebody internally, who's gonna be hands on managing a big chunk of the business for you, you know, that's gonna be a very expensive hire. And it's kind of binary, either you have that manager or you don't. And so when you add that manager, your costs stepped up quite a bit, and it's a fixed cost. And now we're usually are in a bit of a hole and we have to grow revenue and put a lot of pressure on ourselves to grow that top line to get an ROI on that manager. And, you know, growing the business 50% only pays for that manager. It doesn't leave any profit leftover so we really need to grow the business more than 50% to get that get that positive ROI. 

Cal Wilder  25:02
One of the metrics we use to help clients with capacity decisions is labor value multiple or LVM. So in case for this workbook, it's not really a, we're not really trying to answer the question of how much do we need to sell in order to make a particular kind of hire, really honing in on this labor value multipolar LVM metric, because we can go do all this financial analysis every time we want to make a new hire. But for some business owners, it's kind of daunting if they're not that financially inclined. And so LVM is a simple metric we can use to help make hiring decisions if we've got a business that has pretty well established profit margin, relatively stable pricing structure or stable revenue. So if you can predict what your revenue and costs are going to be, then LVM is kind of, for lack of a better word, a dumbed-down metric that is very powerful that can be used to help answer these hiring decisions. If the hiring decision is, can I hire another technician in an IT MSP? Or can I hire another online marketing specialist in a marketing agency? People who are actually delivering the revenue where we need a certain amount of capacity in order to deliver a certain amount of revenue. In that situation, LVM helps us answer the question, can I afford to hire another employee? And it can be very useful if we're trying to delegate hiring decisions to other managers. 

Cal Wilder  26:38
So what let's talk about exactly what is LVM? How do we define it. It's defined as gross profit divided by the wages of the people who are delivering the revenue, so we call those direct wages, right. And so gross profit, remember, is revenue minus third party cost of goods sold. So in our example, we're using it's a million dollars in revenue with $300,000, paid out to Google or Bing or Microsoft or whoever. So that leaves us $700,000 of gross profit. And in our business example, here, we've got, you know, 30% of revenue being spent on cost of service, and of that $300,000 of cost of service, $250,000 of that is wages, salaries. And so to calculate our LVM, we're taking the $700,000 of gross profit and dividing it by the $250,000 of direct wages. And that gets us an LVM of 2.8. Said another way, for every dollar that we pay in direct wages or salary to the people doing the work, we need to be generating and supporting $2.80 of gross profit. And that really means probably close to $3.50 of revenue before we have to pay our third party cost of goods sold. And so we know in this model, that if we're aiming for about a 40% contribution margin, we need about a 2.8 LVM to get there. 

Cal Wilder  28:17
LVM is a function of really a small number of variables that that move the needl. Pricing, wages, salaries are fixed. And so if we can price a little bit higher, that's going to generate more gross profit over the same wages and increase our LVM. Or it could be driven by utilization, if our utilization is low, then we've got excess capacity, and we're paying some wages that aren't really being utilized to generate revenue. And so low utilization will depress the LVM. Or we may have some overhead in there, we might have a service delivery manager. And so if we, we have to gear the overhead level, appropriately, if we have too much overhead in our service department, then that will depress the labor value multiple because the overhead is not generating revenue to help pay for the salaries in the department. And so, when it comes to hiring decisions, we can say, okay, we need about a 2.8 LVM to hit the profit margins need to so if we're up to 3.1, 3.2. People are pretty busy, you know, and we have some confidence that our sales are going to keep growing, that would indicate we can afford to make a new hire and maybe we need to make a new hire because we don't want to burn out or our valuable people. Or if we see our LVM down you know, 2.5, 2.4, 2.3, you know we have a problem there. You know if revenue is holding steady, then we've got a cost structure issue. We may have some excess capacity. Utilization might be low. Overhead might be a little bit high. So if the LVM is a little too low, we're not going to be hitting our profit margin targets. So we need to dig in and figure out what we need to do to get LVM up to 2.8. 

Cal Wilder  30:21
And if I'm the owner, and I want to have a larger business, and I've got a service department manager, I can tell that manager, hey, our objective is to deliver a 2.8 LVM this year. So if you come to me and say you want to make a hire, well, make sure we're still going to hit our 2.8 LVM. This year, maybe you make the hire and it dips down to 2.4 and 2.5, temporarily. You know, that's okay, as long as it's temporary, but we got to make sure we hit 2.8 for the full year. And so the managers may even be less inclined to dig through all the financial analysis and the income statement and chart of account. The manager is going to know the salaries of the people in the department they manage. They're going to know the revenue that the department is delivering. So they can do the simple math of revenue minus any third party cogs equals gross profit. They know their salaries. If they want to increase salaries, then they know what gross profit needs to be because it take the salaries times 2.8. And that's how much gross profit the department needs to be delivering. So it can be a quick and easy guide for making capacity decisions both when revenue is growing, and we might need to add capacity. And on the flip side, unfortunately, if revenue is shrinking, we might need to cut some capacity. Labor value multiple tells us kind of where to aim.

Cal Wilder  31:40
And kind of embedded in this, in these cases and analysis is some ability to predict and forecast the future Lindsay, right? And this is something you work with clients on regularly. So what's your approach to forecasting when we're trying to answer some of these questions?

Lindsay Jarosch  32:00
Yeah, forecasting is incredibly important in all these decisions. Before I get into it, just one more plug for label labor value multiple. I feel like it's the least talked about and most powerful metric. And it really makes things we talked all about all these different cases and everything. But it really makes things very clear to business owners who maybe don't want to go through all of the different cases and different analysis and really just want to look at something that's a little bit more black and white. So I use it frequently. And it's incredible in terms of the story that it tells. 

Lindsay Jarosch  32:36
So now forecasting. So a lot of this does depend on you know what revenue looks like in the future. Accountants always tend to tell you what happened in the past, we account for things. But what you really need is confidence in the future. And that's really what you're basing your new hire on. So when we talk about forecasting, the most important part of forecasts is the revenue forecast, because that's really going to dictate the spending decisions, and really help you understand what you can afford to spend, and if you'll have profit leftover. So first and foremost, we look at forecasting revenue. Sometimes it's easy to forecast revenue, it's predictable, and pretty consistent month over month. Sometimes if it's project based, it's a little more tricky. But really, that's the first thing that we look at when we're trying to forecast to make hiring decisions. Other things we'll look at after after revenue is the fixed and the variable costs. Fixed costs are really easy. Those are things like rent, things that you know that you're going to spend every single month, variable variable costs are a little bit tricky. Or they can be generally, you can come up with some decent percentage as a percent of revenue, and then try to get good forecasting around variable costs.

Cal Wilder  33:56
Right. So variable costs in the examples we're looking at here would be our cost of service. You know, in the short term, salaries are fixed. But if we dramatically, you know, grow revenue, revenue goes up a lot or down a lot, then we're going to have to add or subtract salaries in our service department. So in the short term, cost of service could be fixed. It's not going to cost us any extra if we don't hire anybody, and we deliver a little more revenue next month. But in the long term, if we grow the business 50% or we doubled the business, then our cost of service as a percentage of revenue is you know, going to stay relatively fixed. But in dollar terms, it's going to go up as a variable cost with incremental revenue over time.

Lindsay Jarosch  34:45
Yeah, and you know, once as also part of forecasting, will look at the net profit and often we'll do a sensitivity analysis on how much net profit changes when revenue goes up or down. It is really helpful to understand sort of where you're going to be at the end of the day, especially when you're considering the question, can I afford a new employee. If you're not highly confident in your sales forecast, it may be great to optimize around your current size instead of trying to grow or justify a new hire. Really, if you don't know where you're going to be in 12 weeks, you know, six months, then sometimes it's good to just sort of wait it out and see where you're going to be. Or maybe you're in a limit of what you as an owner can manage. And adding more service people to deliver more revenue might mean a step function, or adding a new manager in order to deliver more revenue. 

Lindsay Jarosch  35:46
Again, like we saw in the examples that we just presented, managers are expensive, and they don't personally deliver much if any revenue. So the step function cost increase might just be too expensive and too risky to try. So a lot of things to consider as you're trying to add a new, a new employee. The tendency is that, you know, you always want to grow, but sometimes optimizing profitability around current headcount is the right decision. Maybe raise prices utilize part time subcontractors, resigned from unprofitable client engagements and figure out how to get a few more percentage points of utilization from existing staff. So while we all want to grow and hire new employees, really, sometimes the right answer is to, you know, optimize your profitability with what you have.

Cal Wilder  36:42
Right? And this comes back to step one of the financial operating system, which is getting clarity around why you own the business, and what are you trying to accomplish financially with the business. So, if you've got that million dollar business, and you know, you're trying to pay the mortgage and the kids' college education, you need a certain amount of money to do that. But you might not need a $5 or $10 million business to do that, right. And you could be perfectly happy running a one or $2 million business. And if making that next hire means you're gonna have to go from $2 million to three and a half million dollars in order to pay for that hire, you may not want to do that. It all comes down to what your objectives are, as the business owner, and then informed by the financial analysis and what the numbers tell you you need to do. 

Cal Wilder  37:37
I would probably be remiss if I didn't put a short plug in here for making sure that after we make that hire, we do our very best to make that person successful. All this analysis we do to justify the hire is really the easy part of it. The hard part is, once that person shows up for work on day one, how do you make them successful. Because it's very expensive to hire somebody who doesn't work out, who either leaves for another opportunity, or you have to let them go, before they've contributed lunch to your business, and certainly before they've come close to paying for themselves. And so we really need these metrics in place more operational metrics, what I would call leading indicators, meaning they represent current activity in the short term that we do daily or weekly, that lead to those longer term successful results. We talked about leading indicators and metrics and weekly scorecards and prior podcast episodes, I would suggest checking out episode number 10, and number 12, that really go into detail on metrics and scorecard. But the whole idea here is we're trying to measure progress along the way. So we don't find ourselves 90 days or 120 days into a new hire, when they're not coming close to paying for themselves. And so we're going to prevent that from happening through good management practices. Lindsay, anything else to add around this topic, when we're trying to answer the question of can I afford to make a new hire? Or how do I get an ROI on a new hire?

I think really thinking about what is the ROI on the new hire, and really looking at some of the different cases. LVM will really help kind of get to that answer whether you should hire a new employee or not.

Cal Wilder  39:33
Yeah, re: LVM we should probably do a separate whole episode on LVM because there's so many different ways that can be valuable. 

Cal Wilder  39:42
Let's let's wrap up this episode today here. So if we're trying to recap everything we talked about, you know, I think the the primary point I would make is that hiring somebody is an investment and we need to measure return on investment. We need to be clear on what we need to do to get a return on investment. I remember when I was younger, one of my mentors told me to think of spending as investments. If I'm going to spend some money on something, is this an investment? Or is this an expense? You know, maybe there are some things like, you know, the electric bill that keep the lights on in the office, that just kind of an expense that you have to incur if you have an office, right. But a lot of the big decisions like adding a new employee, you know, those are optional. And so they're an investment. We don't need to do it, we can do it. But we need to make sure we get a return on that investment. Right. And it's not a question of can I afford to spend money on something? It's a question of how do I get a return on that investment? So let's let's keep that in mind as we try to answer this question. 

Cal Wilder  40:57
Lindsey thank you for your time today. If anybody wants to get in touch with Lindsay or me, the best way to do it is go to our website smartbooks.com. And right on the homepage there there's a link you can click to schedule a free consultation with us. We'd be happy to talk to you and and help you answer these questions for your own business. 

Cal Wilder  41:20
Reference show notes and find other episodes on EmpoweringHealthyBusiness.com. If you would like to have a one-on-one discussion with me, or possibly engage SmartBooks to help with your business, you can reach me at Cal@EmpoweringHealthyBusiness.com or message me on LinkedIn where I am easy to find. Until next time, this is Empowering Healthy Business, the podcast for small business owners, signing off. 

Employees as Profit Centers
Return on Investment vs Affording a Hire
How Much Do You Need to Sell to Afford a Hire?
How Much Does a Salesperson Need to Sell to Pay for Themself?
How Much Must the Business Grow to Hire a Manager?
Labor Value Multiple
Forecasting; Fixed & Variable Costs