Earn the Right to Grow: The Two-Line Ratio and How to Move It

Bill Canady: Thousand Days. That's enough time to transform a company, but not enough time to waste. Welcome to the 1000 Day CEO, the podcast about decisive leadership, sustainable growth, and building a business that thrives beyond any one leader. Your host is Bill Kennedy. Let's make every day count. Day one hundred and sixteen. I'm in a conference room in Ohio with a CEO who has built me a very good deck. Thirty-one slides. It's the gross plan and it's not a stupid one. Eight new sales heads, two branch openings, one new region, four point one million dollars of investment, all of it paying back inside of twenty six months on his math. He presented it to the board twice, and he wants me to tell him how to sequence the hires. And I say, before we do that, can we pull the P and L? He looks a little annoyed, which is fair. He's been talking about this future for 40 minutes, and I've asked him to look into the past. We pull off two lines of it, two, take about half an hour, most of which is arguing with the controller about what belongs in which bucket. And we write a single number on the whiteboard, 1.6. And the room goes quiet. Because two of the four people already know what that number means, and they've known for a while, and nobody has said it out loud. So I said out loud. I told him he was not going to hire eight salespeople. I told him that if he hired eight salespeople, he'd be a bigger, busier, and less profitable company in eighteen months and the board would replace him for it. And he would never quite understand why, because revenue would be up the whole time. He did not love hearing that. He also did not hire them. So hey, we had that going for us. Now look, here's the proof. The company entered the whole period at one point six. Fourteen months later it crossed two point zero. Not by cutting people. Headcount was within nine of where they started. It crossed by working on price and mix and working on it hard for four straight quarters. And that is the ordinary result, not the heroic one. A business that enters the hold at 1.6 and works price and makes hard typically crosses 2.0 in twelve to eighteen months. 12 to 18. That's the honest number, and I want you to hear it in your head from the top, because this is a project with a year and a half in it, not a quarter. Now here's my promise. By the end of the next half hour, you'll be able to calculate from two lines on your own profit and loss statement whether your company has earned the right to grow. Two lines. About 30 minutes, one verdict. You'll know which of the two tracks you're on, and you'll know what actually moves the number and what only looks like it does. And here's the plan three moves. Calculate the ratio this week off your trailing 12 months. Plot it against the same quarter last year so you know which direction you're traveling. And then declare a track out loud to your leadership team. And stop funding everything inconsistent with it. You can run one more move before Friday. This is the thousand day CEO. I'm Bill Kennedy, and let's get into it. First, the problem. Most CEOs try to grow before they've earned it. That's it. That's the whole failure. And it's so common that I now assume it in the first meeting until somebody proves me otherwise. They made the business bigger and less profitable at the same time. And they don't do it out of vanity. They do it because growth is a thing they were hired for. Growth is the thing the board asked about. And growth is the only activity in a company where everybody in the room agrees on the direction. Nobody's feelings get hurt in a growth meeting. Everybody's feelings get hurt in a simplification meeting. So here's the distinction I want you to carry. I need you to carry it. I'm going to repeat it all season. Growth without profitability isn't growth. It's acceleration into a wall. Now that's not growth. That's expansion. And there's a huge difference. Growth is why you add a dollar of revenue and keep a bigger share of it than you did the last year. Expansion is when you add a dollar of revenue and keep a smaller share of it than you did last year. Big difference. Now both look identical on the top line. They diverge on the bottom line about four quarters later, which is exactly long enough for you to have hired against the wrong one. Now here's the mechanical part, and this is the part that's not an opinion. The company has an engine that converts revenue into profit, segmentation pricing, segmentation product mix, the cost to serve, how much complexity the operation is carrying. Until that engine works, every additional dollar that you bring in actually makes the problem worse because you're scaling the dysfunction. You're not growing the good thing. You're manufacturing more of the exact thing that's already hurting you. And doing it faster with more people using capital. The sponsor gave you. I'm gonna tell you right now, they're not gonna be thrilled about this when these numbers roll across. Profitable growth in that order. Profit first, then growth. Reverse them and you'll be running harder every year, making less money, and wondering why. Now I want to head off something here, because I've heard this phrase land wrong in a hundred rooms. Earn the right to grow is sometimes heard as a moral statement on the order of you get only what you deserve. Well it's not. It's a statement about probabilities. I'm not telling you you haven't suffered enough yet. I'm telling you that a business below a certain operating threshold has a demonstrated, repeatable tendency to convert incremental revenue into incremental costs rather than incremental profit. Now that's not a character assessment. That's a machine with a known behavior. You would not put more fuel through an engine that's currently converting fuel into heat and noise. You'd fix that engine, same logic. No moralizing required. And here's the full principle, which is longer than the slogan and way more useful. A business that cannot reduce its complexity does not earn the right to grow. A business that cannot redeploy resources from low-value activity to high value activity does not earn the right to grow. There's two tests, and you can take things away. You can move people and money from where they are to where the profit actually is. If you can't do either of those, you don't have a growth problem. You have a permission problem. And no amount of revenue will fix it. It's just a more expensive fix later. Let me put a cost of what is getting this wrong in dollars and in days. Dollars first. Take the CEO in Ohio, 4.1 million of investment, eight salespeople who each need something like 18 months to carry themselves. If he'd have hired them at 1.6, here's what happened. And I've watched it happen enough times to know that I could have written the memo in advance. The news tellers do their job. Now they sell well, they sell what's easiest to sell, which is the tell, because the tell is where discounting authority already exists, and the competition is weakest. So revenue goes up six, seven, eight percent. Material margin percentage goes down. Operations absorbs a bunch of new order lines it wasn't staffed for. Customer service headcount goes up to cover it. And the ratio, which was 1.6, is now 1.5 on a bigger, more complicated company that is harder to fix than the one he started with. He would have spent four million dollars to make the problem more expensive to solve. Nowadays, this is the part that actually kills people. He'd burn 18 months finding out, 18 months on a thousand day clock. That's not a mistake you correct. That's a mistake you get replaced for, because you will be presenting the correction right around month 20. Which is precisely when the board's patience runs out and somebody starts using the word co-pilot. So before you fund anything, you measure. Let me give you the measurement. All right, here's the framework. The right to grow ratio. I always love saying that. It's kind of just fun to do. But what it is is material margin divided by total fully loaded employee costs, right? So it's the money you're making off of your material divided by your employees going into their total costs, right? That's it. Two lines. is computable from your own profit and loss statement about 30 minutes. And the only reason it takes 30 and not five is that both lines are usually wrong the first time you pull them. So let me walk you through each one and more importantly, the traps in each one, because the traps are where people fool themselves. You know, let's start with the numerator, the ⁓ material margin. Material margin is revenue minus the truly variable third party cost of the thing you sold. Materials, purchase components. Subcontracted production, inbound freight, outbound freight, duty, royalties. And this one gets missed constantly, rebates, cash discounts, and co-op payments you pay to move the product. Now that's it, nothing else. Trap one, and it's a big one, material and margin is not gross margin. Your ERP has a field called gross margin, and it's tempting and it's wrong for this purpose. Because gross margin has direct labor absorbed into it, and usually a slug of manufacturing overhead. And sometimes an allocation nobody currently employed at the company can even explain. We've all been there and seen that one. Good luck trying to explain it. If labor inside of your enumerator and also inside of your denominator, the ratio measures nothing. Strip it out. Okay, trap two. Rebates and discounts that live below the gross margin line. We know them, we see them all the time. They're filed under marketing or customer programs. Pull them up. That's not marketing. That's price. If you leave $14 million of rebase down in SGNA, your numerator is $14 million too generous. And your vertical be too kind. So pay attention to it. Let's get it up there. Trap three, inner company. Classic one. You got a little bigger organization. Left hand is selling to the right hand, right? The one pocket to the other. We do it all the time. If you got them selling to each other, the transfer price is a decision somebody made, not a fact of nature. Eliminate it and use the outside cost. It's a simple way to do it. Keeps everybody honest and on the same page. The the denominator, the totally fully loaded employee cost, every so now to the denominator, the total and fully loaded employee cost. Everything you spend to have human beings fully loaded means fully loaded. Just that. It's everything. It's wages, salaries, overtime, bonus and commissions accrual, payroll taxes, employer contribution to health, dental retirement, workers comp, contract labor, temp agencies, lease employees under a PEO, and the direct labor sitting inside a cost of goods sold, which you just stripped out of the numerator and which now belongs down there. Okay, so you're getting the idea. Just cause they're attempts, still gotta go in there. Okay, trap number one, direct labor buried in your cogs. Most controllers will hand you an SGA payroll number and stop. That's not the denominator. That's a third of the denominator. Trap two, contractors hiding in professional services and outside services. If a person shows up on Monday and through Friday and does work of an employee would do otherwise. That's an employee call, so don't strip them out. Regardless of where it's booked, put them in the employee calls. I know you have them in there, it can be an ad back, but you still need to count them. I've seen companies where 11% of the total workforce was invisible to the payroll report. Trap number three, the PEO invoice. One line, one vendor, 60 people. Open it. Do those two lines honestly, and you have a number. All right, the bands. Here's how to read it, and these are where the numbers I use. Below 2.5, you've not earned the right to grow full stop. 2.5 to 3.5 is a typical healthy middle market band. That's where a functioning industrial distribution business ought to live. 4.0 is exceptional. You find yourself there, you want to put a little more gas into it, want to go a little faster. If you're at four and you're running an unusually clean engine, and the question is Why aren't you pressing the accelerator harder? It's time to get on it. Now the caveat, and I want to say this in plain language rather than bury it, the exact threshold varies by industry, capital and tendency. A heavily automated manufacturer with a lot of machinery and a relatively few people will run slightly higher because the machines are doing the work that shows up in your numerator, not in your denominator. A services business, an engineering heavy business, anything where the product is substantially people will run structurally lower. And two point two is perfectly healthy there. So calibrate the level against your own industry. Remember, thinking is required. The bottom line is you want to get better. So calculate the number, figure out where you're at, and start making it better. But here's the thing that matters more than the level, and this is the part almost nobody does. The direction of travel is Matters more than that level. So I just said, get better. Focus on getting better. And I want to be very clear about why, because this is the part of the episode I care about most. The number's not a grade. It's not a judgment on you, your team, or the business you inherited. It's a starting position. It's where you're coming out of the gate at. And there's no starting position on this scale that cannot be improved. Whether you're at one or four, you can always get better. So there's none. I've never once seen a business where the ratio couldn't be moved. And I've looked at a lot of them. The engine is always fixable. The engine is always fixable. The only question is whether anyone has decided to fix it. So if you run this and the number comes back low, the correct reaction is not embarrassment. The correct reaction is good. Now I know where I'm starting from and I know what the next two tenths are going to cost me because that's the real unit of work here. Not the band you're in. The next two tenths. A company that moves from one point four to one point seven and three quarters is doing better work than a company sitting flat at two point eight, even though one of them is inside the healthy band and the other isn't. One's getting better. That's what we like to see. The first one has a functioning improvement engine. The second one has inherited good luck and is spending it. A company at two point one that was at one point eight a year ago is a company I want to fund. This thing's getting to be a rocket ship. A company at 2.9 that was 3.0 a year ago is a company in a problem that hasn't been named yet. And the fact it's in setting inside, and the fact that it's setting inside the healthy band is actively hiding it. Levels tell you where you are. Directions tell you what's happening to you. All right, as I said, there's two tracks. Once you have the number, you're on one of the two tracks, and I want you to say which one it is out loud. Above threshold. You're on the growth track. Fund that growth plan. Add sales capacity. Go take share. It's time to get after it. You got an engine that converts revenue into profit. So the more revenue you push through it, the more profit comes out the other end. That's the whole reward for having done to work. Now, below that threshold, you're on the fixed first track. And on that track, the instruction is blunt. So I'm going to be blunt. Do not fund the growth plan. Do not add sales capacity. Not slow it down, not phase it, just don't fund it. Every dollar you put into man generates a broken engine coming back as cost. But hear what the fixed first track actually is because the CEOs hear it as penalty bar. And it's the opposite. The fixed first track is the highest return work available to you in the entire thousand days. Nothing else you can do with that four million dollars returns what fixing the engine returns, because fixing the engine. Changes the yield on every dollar that comes after it. Forever. You're not being told to sit still. You're being told where the money actually is. You want that four million dollars? Spend it on segmentation, the pricing, and the complexity removal. And come back in four quarters with a number that lets you spend it on growth properly. All right, here's what moves the ratio. There's three things that do it in order of speed. First, price. No shocker there, huh? It's always the one. It's fastest lever you'll ever touch because it goes straight to the numerator with essentially nothing standing in front of it. It's no friction. Two to four points of realized price, which is what a serious corridor cleans up, which is what a serious corridor cleanup delivers, not a general increase, a cleanup of exceptions and stale discounts is worth 0.1 to 0.3 on the ratio inside of two quarters. That's significant. That's material. And that's a full episode by itself, and it's episode number six. Next comes mix. It's slower, it's bigger, higher. You retire tail revenue that carries low material margin, and you redeploy the free capacity into the segments that carry high material margin. Notice both halves of that one sentence. Retiring alone doesn't do it. You retire and redeploy. It's absolutely critical. Next comes complexity removal. Well let's be honest. This is the slowest one. It's the most durable, and it's the one that makes the other two stick. Now, what doesn't move it? Head count cuts. You would think it would. Hey, I see it all the time. It means less employees. Well, guess what? Head cuts by itself isn't going to make a difference. I know every instinct says otherwise. The denominator is employee costs, so cut employees. Denominator drops, ratio goes up. It's just basic arithmetic. Well, it's not arithmetic, and here's why. Let me do it with the real numbers. A hundred and eighty million dollar business. Material margin sixty three million, thirty-five percent. Not too bad. Fully loaded employee cost 28 million. 63 over 28. 2.25. Below threshold. Time to fix it. Let's get on the fix it track. Now, cut 10% of that workforce across the board and And the way it actually happens, a percentage handed down to every function so it feels fair. Employees' costs go from twenty-eight to twenty-five point two. Full and pretty good. We just picked up a couple million bucks. But the employees that you just cut were producing material margin. They were quoting, selling, servicing, engineering, expediting. Cut 10% of the capabilities and material margin comes down with it. Didn't think about that, right? They go out the door. Who's going to bring those orders in and ship them? So call it 10%, which in my experience is generous to you. 63 becomes 56.7. Hmm. Doesn't feel so good. 56.7 over 23, over 25.2, 2.25. You're exactly where you started. You ran all that, worked so hard, didn't move the needle at all. You made the company smaller at the identical ratio. The remaining people are now doing the work of people who aren't there. And you have spent your one credible restructuring on nothing. Doesn't feel good. Now, the ratio rewards capability, not thrift. Now, there is one exception, and it's important. Cutting people who are attached to work you have actually stopped doing is completely different. That's not thrift, that's the second half of the principle. Redeploying resources from low value activity to high value activity. You retire the tell. So the four people who service the TEL move to segments that pay or they leave. That moves the ratio and it moves it permanently. The test is really simple. Did the work go away first or did the people go away first? If the people went first, you're going to hire them back inside of a year at a premium. And that's going to make you feel pretty bad. All right. So here's an example back to our $180 million of business at 2.25. Here's the real path. Price. A corridor cleanup delivers one and a half points of realized price. On one hundred and eighty million, that's two point seven million dollars. Essentially all of it straight to material margin. We love that. Sixty three goes to sixty five point seven, ratio two point three five. Looking better. Now mix, retire seven million dollars of tell revenue running twelve percent material margin. That costs you eight hundred and forty thousand of margin. And if you stop there, the ratio goes down. Not the way we want, unintended consequence, which is the trap that make people quit halfway. But if you freed capacity, redeploy it in quad one, the fork, segments running 41% material margin. $7 million is 2.8. $7 million there is $2.7. $7 million there is $2.87 million. That's a netted to plus two million. We like those numbers. So you gotta shift it from where it's not making money over to where it is. 67.7 other over 28. Okay, so 67.7 over 28. 2.42, headcount unchanged, same 28 million, different work. All right, two quarters later, you do it again, and you're through 2.5 and you're on the other track. And now the four million dollars for salespeople is a good idea. Instead of a failure one. No, these numbers can get a lot at you, but if you just take and write them down, I think you'll find it really makes sense to it. So this is what 12 to 18 months like from looks like from the inside. It's not dramatic. It's four consecutive quarters of two moves each, which is exactly why so few people finish it. So watch the plan. It's three moves. The first one this week. Move number one: calculate the ratio. Take the trailing 12 months, now not the budget, not the forecast, not the last quarter annualized, the trailing 12, TTY. So because it's the only version nobody can argue with, sit down with your CFO and your controller for one hour. Build the numerator. Revenue minus materials, purchase components, subcontract, freight in and out, duties, royalties, rebates and cash discount. Build the denominator. every dollar of human cost anywhere in the business. Real simple. Find them all, add them up. There's your denominator. Include direct labor costs and cocks, including contractors, including the PEO. Then divide. One warning, your finance team will want to build a model. Don't let them build the model. It's a waste of time. A model takes six weeks and produces a number you don't trust because you didn't watch it getting made. You want two numbers on the whiteboard in an hour. arrived at by argument in front of you. The arguing actually is the point. That's where you find out that 11% of your workforce was invisible. Okay, second move. Plot the direction of travel. Do it again for the same quarter one year ago. Same definitions, same buckets, no adjustments needed. Now you have two dots and a line between them. If the line is going up, whatever you're doing, do more of it. We like that. And be able to name what it is. If the line is flat, you're carrying by the market, and you should be assuming that the market will stop carrying, right? Trees don't grow to the sky. Prepare to fall. If the line is going down, that's your emergency. And it's your emergency regardless of what the level set. I've had CEOs come back to me delighted because they're at 2.8, comfortably inside of the healthy band. And then we pulled last year, and last year was 3.2. The delight goes away quickly because a business shedding four tenths a year is eighteen months from the first fix it track and nobody's even noticed. Two dots, one hour, that's the whole diagnostic. Simple bimple, you can do this no problem. Third move, declare a track out loud and stop funding the other one. This is the move people skip, and skipping it makes the first two direct decorative. You stand up in front of your leadership team and you say the number and you say which track it puts you on and you say what that means for the next four quarters out loud in a room with a number on the wall. If you're on the growth track, say it. Fund it and go. If you're on the fix it first track, say that too. And then do the hard part. Go through the current year's spending commitments and stop the ones that are inconsistent with it. The sales headcounts for equal requisitions. The sales headcount requisitions, the new branch, the trade show budget for a segment you're about to exit, the channel expansion. Stop all those. You don't need it. And when you say why in the same breath, or your team will hear we're not investing, and conclude you've lost your nerve. What you're actually saying is we are investing all of it in the engine for four quarters, and then we're going to spend it on growth from a position of where it works. So here's a phrase for it earn the right. Then and only then accelerate. What does it look like when it's working when it's theater? So what does it look like when it's working and when it's theater? Now the first track has been defined shape. Now the fix it track has a defined shape, and I want to give it to you the checklist because we're working on it is the most expensive sentence in the middle market. The first hundred days of earn the right to work is different. The first hundred days of the earn the right to work. And this is different clock than your first hundred days in the seat. This is phase one of phase two. It has nine deliverables. None. And here they are. First, a segment level profit and loss statement. Not a customer list or a revenue next to it, a PL by segment with material margin and cost to serve. Second, every segment classified quad one through quad four. Third, the right to grow ratio calculated. With direction of travel. Is it going up or down? Just gotta look back. Fourth, a documented quad four decision. Exit, reprice, or starve. Write it down with a name against it. Five, do the dirty dozen kill list with at least six items actually retired. Not identified, retired. You gotta get it done. Number six, a zero-up rebuilt budget. Built from zero, not from last year's plus five. We all know how that works. We're not trying to stay the course we're trying to build. Seventh, a live X matrix with five to seven priorities. Five to seven. If there's twenty five on it, go back and read episode two. Eight, live bowlers, your KPI scorecard with countermeasures written against every red. Nine, the first monthly business review run on the new system. The NBRs are powerful. It's gonna track your KPIs. You'll figure out what's working. If you finished phase one without those nine things, you didn't do phase one. You just did orientation. Feels good, not enough. That's the tell for theater, by the way. Theater has slides for the nine deliverables should be. Theater has work stream charts with 11 swim lanes and a project management office. Theater is super busy. We've all seen it. We know what it looks and feels like. Working looks like this: a segmented PL that a room can argue about. Six things gone. One number on a whiteboard and a monthly meeting where variances get causes and countermeasures. Not objectives. Three things worth keeping. First, material margin divided by total fully loaded employee costs. Below 2.5, you're not earn right to grow. 2.5 to 3.5 is a healthy middle market band. Four is exceptional. You're a rock star. Calibrate the level to your industry's capital intensity and watch the direction of travel harder. Then you watch the level. It's more important where you're going. Are you going up, down, or flat? The number is a starting position, not the grade. It's not the final destination. If you did good, good. Go faster. If you're not doing so great, get better. Every business on this scale can move it, whether it sits today, wherever it sits today. And the unit of work is the next two tenths, not the whole band. Second, price mix and complexity removal move the ratio. Head counts don't do it. I know it's shocking, but it's true. When you cut people across the board, the numerator and the denominator move together and it nets next to nothing. You get a smaller company with the identical problem and fewer people to fix it. The ratio rewards capability, not thrift. Third, two tracks. You have to declare one. Above threshold, fund the growth plan. Below threshold, do not fund the growth plan. Do not add sales capacity. Spend the money on the engine and come back in four quarters. A company at 1.6 that works price and mix hard crosses 2.0 in 12 months to 18 months. That's the timeline. It's a project, it's not a quarter. That's really the whole argument of this episode. So let me put it in one line. Earn the right to grow. Then and only then accelerate. The CEO in Ohio still has the deck. 31 slides, eight salespeople, $4.1 million. He'll get to run it. He's going to run it about six quarters later than he wanted to, out of a business that will actually convert it. And he'll still be in the seat, which is more than I can say for a lot of people who ran their version of schedule, who ran their own version on schedule. Now, next week we'll go after the timing that's holding your on the next episode, we'll go after the thing that's holding your ratio down. And it's almost never what you think. It's Quad 4, your bottom value customers buying your bottom value products, and the 12 places of complexity that hide in a middle market company. I'll tell you about $310 million industrial business where 4% of revenue was eating a third of the capacity. What happened when we froze the discounts? And what happened when the weekend we moved 187 accounts to credit card on order? Twenty-two of them said no. That was the good news. If you want to run today's calculation, the worksheet is at the 8020 Institute. You can find it inside there. Go and take a look, sign up for it. I'm sure you'll enjoy it. I'm Bill Kennedy. Go run your numbers. Have a great day. You've been listening to the 1000-day CEO with Bill Kennedy. Follow the show for more decisive leadership, sustainable growth, and strategies that build enduring businesses. Until next time, make every day count.