Avoid the Death Spiral: Investing in Your Employees and Increasing the Bottom Line

This resource is designed to highlight the relationship between investment in employees and growing the company’s profitability. This resource discusses how companies can invest in their employees, determine the fully-loaded costs of their employees, and key indicators to determine if the investment is increasing the company’s bottom line.  

The Virtuous Cycle vs. the Death Spiral

Upon hiring its first employee, the business owner makes a crucial decision: whether or not to further invest in this employee through the reinvestment of a portion of net income.  The result is either the Virtuous Cycle or the Death Cycle as shown below.

 

Virtuous Cycle

In the Virtuous Cycle of Business Growth, investing in employees ensures that they are provided the appropriate environment to grow and become more productive.  Productivity is measured as more value per ounce of effort. More productive employees allow the business to adequately service their customers to drive net income.  Increased net income brings more opportunity to invest in employees and thus, continue the cycle to further company growth and profitability.

There are two primary ways in which companies invest in employees: 1) training and 2) systems. Training involves direct investment in employees such as providing routine internal training sessions, attendance at conferences, Continuing Professional Education courses, classes, etc. As employees grow in knowledge and technical skills their work will be enhanced. For example, Samantha’s Cake Shop may provide on-the-job training for their new employees. They might also choose to send a baker to a class to learn more about the ingredient components as they consider elements such as preservation for shipping online orders. Likewise cake decorators may be sent to classes to learn new decorating techniques or new technology to transfer an image on to a cake.

Regular performance reviews are another way to invest in employees. By providing regular feedback and establishing goals and targets, employees have a clear understanding of areas that need growth and areas in which they are successful. Performance reviews also help managers to see areas in which employees would benefit from additional training.

Second, investing in a series of systems for the company allows an employee to be more productive and effective. These systems might include templates, checklists, forms, standardized methodologies, and technology systems. Standardized procedures allow everyone from administrative assistants to surgeons to be highly effective and thus more profitable. An administrative assistant might have template engagement letters to reduce recreating the same letter multiple times, a checklist for supply ordering, and standard expense forms for reimbursements. In Complications: A Surgeon’s Notes on an Imperfect Science Dr. Gawande cites the increased effectiveness and profitability of a basic hernia surgery through the use of a repetitive technique.  Dr. Shouldice developed this system, or technique, which was implemented by all surgeons at his hospital; the result was decreased time per surgery and decreased recurrence of the hernia from an average of 5-10% down to 1%.

Investing in technology systems can also lead to higher levels of productivity when paired with training and monitoring. Tools such as Customer Relationship Management (CRM) software can simply lead to additional data entry time or could bring a higher level of consistent touch with current and former customers. Customers who may have formerly been lost in a rolodex may now through CRM utilization pop-up on a screen as a reminder to touch base. This may result in increased sales. However, it is also important to realize that much of today’s technology has also caused more senior people to be doing increasing amounts of administrative work. Owners and employees alike are answering their own phones and emails or processing credit cards rather than funneling this through a secretary or bookkeeper in prior times.

Overall, the goal of investment is productivity leading to profitability, which is driven by employees working smarter rather than harder. Training, systems, and technology all assist in increased productivity.

Death Spiral

The Death Spiral, on the other hand, begins by choosing not to invest in employees outside of committed wages.  Lack of employee investment results in less productive employees, inhibiting the company’s ability to compete with more effective companies.  The inability to compete leads to competition squeezing profit, leaving less net income to invest in employees. Eventually, the inability to meet market demands due to unproductive employees brings the company to a broken status.

The True Cost of Your employees

When considering the cost of each employee, it is helpful to begin with fully-loaded compensation. Costs beyond wages include Social Security tax, Medicare tax, Federal Employment tax, Workers Compensation, state taxes, and benefits such as healthcare. Benefits can often cost a company an additional 30 percent of the employee’s wages. What is often not considered in employee cost is infrastructure cost, including office space, tools and equipment, administration and other employee-related costs. While these are necessary costs, most are not investments.

Key Indicators for Employees

As a manager or owner of a small business, there are several key indicators to utilize in determining if the investment in employees is sufficient. There are four key indicators to monitor:

1. Revenue per employee: To compute this, simply divide the total revenue for a specific period by the overall number of employees. If a company has $1 million in revenues and 10 employees, this would be $100,000 per employee.
2. Compensation to Revenue: Utilizing fully-loaded compensation as discussed above, divide this number by overall revenues. If the 10 employees cost the firm $525,000 on a fully loaded cost basis with the same $1 million in revenues, this ratio would be 52.5%.
3. Average Cost Per Employee: Again, if the total compensation costs for the firm were $525,000 and there were 10 people, the average cost per employee would be $52,500.
4. Net Profit per employee: Similar to revenue, divide the net profit for a specific period by the overall number of employees. If the company realized $100,000 in net profits with 10 employees, the net profit per employee would be $10,000.

Watching the trends of each of these key indicators over time will demonstrate the results of the investment, or lack thereof, in employees. If the average cost per employee is rising, this indicates a lack of investment in the future as the company probably does not have younger employees which are being trained. While senior people drive the revenue, younger employees drive the future of the firm. Similarly if the net profit per employee is too large this is likely an indication that employees are underpaid.

It is useful to discover what the industry standard is for your company so that it provides a benchmark for comparison. For example, firms such as Goldman Sachs may expect $1 million in revenue per employee. Retail bakeries, however, are more labor intensive and expect an average of $55,000 per employee. Commercial bakers are more capital intensive and thus expect $230,000 per employee.

The Decision to Outsource Human Resources

Although few small businesses have the experience to perform their own human resources functions in-house, most owners typically carry out these functions to minimize costs.  This function includes everything from hiring employees, writing handbooks, keeping up with legal updates, and much more.  The result is usually frustration and eventually the addition of another employee that makes these tasks their job function.

In the interim, many companies choose to outsource their human resource functions to an organization such as Insperity or Paychex.  The very small companies may realize very limited benefits relative to the cost burden, but as companies increase their number of employees, outsourcing is quite viable. Most companies struggle with the costs, but a full analysis of proper HR activity will generally show the costs of outsourcing are acceptable and the efficiency creates a true benefit.

Articles for Further Reading

1. “Finding Profit from Investing in Workers." New York Times, May 2010. 
2. “Investing in Employees" C&EN, October 2008. Four top companies to work for share their policies for attracting and retaining the best talent.
3. “ROEI™: Return On Employee Investment™: How to Achieve It and How to Benefit from It." Sage Employer Solutions, 2011.
4. “Top 10 Tips to Measure Productivity." MeasureProductivity, 2011.

For more information, please contact the Giersch Group for a free consultation at our offices in Milwaukee, Madison or Brookfield, Wisconsin.