What Percent of Your Revenue Should be Allocated to Payroll?
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 a regularly occurring expenditure, but it also comes with strings attached: taxes, insurance, and additional 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 and thus must be effectively designed. It is not simply a matter of less is better, as sometimes less payroll reduces effectiveness. It is about appropriate balance.
Frequently businesses that are stressed from excessive unsupportable debt, look to reduce payroll to improve cash flow. They structure payroll in view of the debt load, looking to support the debt at the cost of payroll reductions and while this may be a common response, this may be counter productive. Balance is the objective with the business purpose and goals in mind. It is excessive payroll that must be countered, especially as revenues are depressed.
Unfortunately, there is no one magic payroll equation that can be applied to every business. However when considering your degree of profitability, taking gross revenue and industry standards into account along with other business functions can aid you in determining a reasonable ratio of payroll to revenue for your business.
A few guidelines: Service businesses, in which payroll is the major cost of providing the service, can take on higher payroll percentages since the payroll is, in fact, producing the revenue. There is likely to be no other significant cost of services to be provided. In such situations, payroll can reach 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 plus the payroll. Same with restaurants, given the high cost of food the payroll must stay under thirty percent.
Your employees’ productivity is the most important number of all and is the amount of production your employees give the business per hour, day or week. This is measured by the individuals output divided by employee cost, and is a huge variable that can be significantly influenced by management efforts. Productivity measures how much is that employee contributing to the revenue and cost of production, the more productive the higher the better.
In order to determine whether you are currently on the right path or if you may be setting your business up for trouble, examine the ratio of your payroll expenses to gross revenue in view of the overall profitability of the company.
Once you have compared these two numbers, look at payroll as a percentage of gross revenue. If your payroll expenditures fall within 15-30% of gross revenue, your business is in a safe zone. Businesses that live within this range tend to be most successful, at least from a payroll perspective. However, as stated there are many businesses, usually within the service industry, which operate with payroll of approx 50% of their gross revenue.
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 “owners draw” it should be included in any payroll calculations to provide an accurate picture of your finances.
Knowing your business’ ratio of payroll to revenue is only the first step in solidifying your business financial condition. The larger issue is choosing to do something about that ratio. Too many business owners are clueless when it comes to reducing payroll while maintaining or increasing productivity. Exploiting this potential is the secret to business stress.
There are a number of ways to accomplish this but the point of this post is to learn how to identify the red zone, where your business is not making enough to be profitable and your productivity and payroll is more than the business cash flow can afford.
First take a hard look at your actual payroll costs, the real costs, which include not only staff salaries but also the “extras” previously mentioned like insurance and taxes. Be sure to also calculate your own earnings accurately, and then compare this tally against your gross revenue. If your percentage falls above 30%, in the red zone, it’s time to come up with a new strategy immediately.
Maintaining a payroll that falls above 30% of your gross revenue is one of the most common reasons for a business to fail.
Identify it first and then we can fix it. Compute the percentage and then call me for help we can help you fix this issue, easily, quickly and safely.
Management by the numbers is the context we hold, and a careful analysis of basic ratios like payroll to revenue, are crucial for controlling your businesses success. Remember, it is not just evaluating how much your payroll costs, while significant, the hidden issue is the productivity of the employees, how much product they make for the payroll paid to them, if we can increase productivity, payroll may balance itself out.
Second Wind has developed its Four Pillar turnaround system, in which Pillar One is management by the numbers, and an evaluation of payroll is a critical set of numbers to be watching and making management decisions because of. Debt workout, Pilar Four is the second area of great concern, as an effectively operating company with the right mix of payroll to revenue, may simply be swamped by unsupportable debt which must be removed and forgiven for the business to emerge and be successful.
To learn more about our debt workout strategies, and how it can handle IRS payroll tax concerns, and any other unsupportable debt, call us, we can help you survive, emerge and succeed once again.