We all know that time is money.
It’s also a resource – and how efficiently you use resources like time and materials, equipment, spaces, and people compared to what you produce is part of the full picture of how well your business is doing.
That’s because efficient businesses maximize the outputs from their resources and minimize their costs, and this makes them more competitive.
No matter how big your business is, you want to make the best possible use of your resources. This means reducing any unnecessary inputs and costs to deliver your product or service (aka your outputs). In other words, you want to increase the margin when it comes to the costs of creating your outputs and the revenue you’re making from them.
Here CWB’s Graedon Rust, Senior Relationship Manager, Commercial who’s based out of our St Albert banking centre, gives us some thought starters for gauging efficiency – as well as optimizing it.
Factors that affect it: “The industry you’re in directly impacts how efficiently it can operate, so comparing efficiency between different industries isn’t going to give you an accurate picture,” says Rust. “That said, control of overhead expenses and control of direct costs are factors that affect the efficiency of all businesses.”
How you measure it: Gross Margin and earnings before interest, taxes, depreciation and amortization (EBITDA) Margin are the two ratios used to evaluate efficiency.
How you calculate it:
__________ = Gross Margin
__________ = EBITDA Margin
What these calculations tell you: A higher ratio indicates a greater efficiency. Both your Gross Margin and your EBITDA Margin ratios should be compared to other companies in the same industry.
“Gross Margin essentially tells you how efficient your core business processes are, whereas EBITDA Margin will give you a more fulsome efficiency calculation because it includes overhead expenses and direct expenses,” says Rust. He adds that different industries will have very different margins. “Low margin industries are usually industries that have larger capital requirements, carrying costs for inventory, a large building, and equipment – for example, a machine shop. High margin businesses are generally service oriented and have less that goes into each dollar, like a doctor’s office.”
How efficiency impacts your business banking: Having low margins compared to industry peers will strain your cash flow, and this can affect your cash flow covenants. What then happens is a reduction in overall profitability.
Cash flow covenants: Typically found in loan agreements, cash flow covenants make it legally binding for the borrower to maintain a certain level of cash flow. This helps protect the lender from risks associated with the loan.
Common challenges: “Lack of efficiency can happen whenmanagement doesn’t truly understand the cost of their product or service and ends up booking jobs that are breakeven or low margin,” says Rust. “Business can also run into trouble when management isn’t being efficient with overhead costs – like the space is too big for the current needs, or there are redundancies in staff, or there’s unnecessary equipment or unnecessary capital expenditures.”
As business models get more complex there are more places to gain efficiencies – and also more places to lose them. And the larger a company gets, the more complex it gets.
Rust explains that retail is generally the simplest form of business as you purchase a product at a set price and sell it at a set price, and your profit is the difference between the two.
“You can find some efficiencies in your overhead, staffing levels, and suppliers but typically there are only so many places you can gain efficiencies. So you need to rely on the product you’re selling to move in significant volume or have a high enough demand to make your margin,” he says. “On the other hand, a manufacturer will have more information and more pivots and data points to be able to gain efficiencies, such as investment in additional machines or labour, or where to source components for their product – and they’ll likely have multiple suppliers, as opposed to a retailer who would have just one or two. Each of these pivot points allows them to gain some margin or lose some margin depending on how informed they are and if they make the right decisions.”
Rust adds a construction company, for example, has even more factors that can increase or decrease their margin, such as sub contractors, deadlines, and estimating.
Solutions that support a business’ efficiency:
Using a Management Information System (MIS) can help you stay on top of inputs like processes, inventory, sales and marketing, and human resources. An MIS can also give you valuable reporting and financials to get a more wholistic view of inputs vs outputs.
“In addition to using information systems, business owners should talk to their financial partner or accountant about how they compare to similar companies and look at where efficiencies can be found,” says Rust. “And in terms of table stakes, they should be having ongoing conversations with their financial partner about their business financials to avoid any surprises, flag and address challenges, and leverage opportunities.”
Related tools and resources: