Business Health Checkup: Pre-Tax Net Income – Operating Expenses

Authors: David Wagstaff and Calvin Longer 

Periodically we will highlight a ratio or benchmark and talk about how you can use these to better understand your business.

The disclaimer: Benchmarks and ratios, blindly applied, can be dangerous. Benchmarks can be useful in understanding areas to investigate, but it’s important to understand what’s being compared and why variances might exist.

The Benchmark: Operating Expenses

The last two month we discussed Pre-Tax Net Income (November) and Gross Margin (December). Jointly they provide a solid foundation to assess a business’s current health. This month we will dig a little deeper and look at Operating Expenses.

Operating expenses are those expenditures that a business incurs in management of the business.   These include selling and general and administrative expenses but do not include the cost of the materials used in the production of the goods or services.

Operating expenses vary widely from industry to industry depending upon the nature of the business. Operating expenses are important because they speak to the efficiency of the administration of the enterprise.

High operating expenses when compared to peers may indicate excessive management or back office functions such as Finance, HR and IT, high occupancy expense, or inefficient sales teams and processes. However, keep in mind each business is different and management may make deliberate decisions to temporarily increase operating expenses. For example, there might be a deliberate increase in marketing expenses to push for growth. Likewise, management might choose to invest in technology to improve competitive position. While these may be solid strategic choices in the short term, operating expenses may be higher than for peers.

During a recent consulting project we benchmarked performance at a sports stadium construction company. The Operating Expenses were approximately 6% higher than peers’ (30.8% vs the comparison group at 24.6%). While the percentage difference may not seem that important, that translated into $310,000 greater operating expense for this business with $5 million in revenue. If all other expenses matched the peer group, that would translate into $310,000 of lower profit for our client. Now that Operating Expenses caught our attention, we drilled down a bit deeper and found most of the differences were in two categories 1) rent and 2) salaries.

• We knew the client recently expanded and upgraded its building. The building looked great and that explained the variance in rent. Now that those upgrades had been completed there was little that could be done to lower expenses in this category and management was satisfied with their decision. No more work was required in this category.
• Salaries were not as simple.
  1. We found some of the difference was explained by family members who brought some great skills to the table but were likely paid higher rates than competitors for similar positions. Since that was a business decision by the owner and related to his own family, those also did not offer much opportunity for improvement.
  2. Finally, as we looked at field labor we found that the company had very high employee turnover. While salaries were comparable to the peer group, the turnover meant the workforce was very inefficient. Projects were taking our client 25% longer than the typical competitor, and on occasion they also had to redo projects. Ultimately this led to the discovery of some field management issues that were causing employees to leave in dissatisfaction or to not work up to their potential.

Once those issues were resolved turnover declined and the company was back on track to outstanding performance.

The example also points to another approach in benchmarking. Rather than just benchmark to peers, it is also possible to compare to historical averages. If the ratios have unexplained deterioration, it may be time to consider reviewing expenses.   Keep in mind that rising expenses may indicate a reduction in operating efficiencies, but a decrease in sales with flat expenses will also cause ratio deterioration.

Operating Expenses – January

Benchmarking reports were retrieved from the Bizminer Database. Industries Examined [NAICS]: General Contractors & Builders [236115.02]; Restaurants [7225; Health Care [62]; Legal Services [5411]; Engineering Services [541330]; Store Retailers [453].

If you are in a different industry or size business or have concerns that your business is not reaching its potential, give us a call.