Earn the Right to Grow: The Two-Line Ratio and How to Move It | EP4

1,000 days. That's enough time to transform a company, but not enough time to waste. Welcome to The 1,000 Day CEO, the podcast about decisive leadership, sustainable growth, and building a business that thrives beyond any one leader. Your host is Bill Canady. Let's make every day count.

Day 116. I'm in a conference room in Ohio with the CEO who has built me a very good deck, 31 slides. It's a growth plan and it's not a stupid one. 8 new sales heads, 2 branch openings, 1 new region, $4.1 million of investment, all of it paying back inside of 26 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&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 2 lines of it to 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 2 of the 4 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 8 salespeople. I told him that if he hired 8 salespeople, he'd be a bigger, busier, and less profitable company in 18 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 we, hey, we had that going for us. Now look, here's the proof. The company entered the whole period at 1.6. 14 months later, it crossed 2.0. Not by cutting people. Headcount was within 9 of where they started. It crossed by working on price and mix and working on it hard for 4 straight quarters. And that is the ordinary result, not the heroic one. A business that enters the hole at 1.6 and works price and mix hard typically crosses 2.0 in 12 to 18 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 2 lines on your own profit and loss statement Whether your company has earned the right to grow. 2 lines, about 30 minutes, 1 verdict. You'll know which of the 2 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. 3 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 1,000 Day CEO. I'm Bill Canady, 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 make 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 the thing they were hired for. Growth is the thing the board asked about. And growth is the only activity in the 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 what 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 4 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 100 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 2 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 on what is getting this wrong in dollars and in days. Dollars first. Take the CEO in Ohio. $4.1 million of investment, 8 salespeople who each need something like 18 months to carry themselves. If he'd hired them at $1.6 million, here's what happens. And I've watched it happen enough times to know that I could have written the memo in advance. The new sellers do their job. Now they sell well. They sell what's easiest to sell, which is the tail, because the tail is where discounting authority already exists and the competition is weakest. So revenue goes up 6, 7, 8%. 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 is 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've spent $4 million 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 1,000-day clock. That's not a mistake you correct. That's the mistake you get replaced for because you'll be presenting the correction right around month 20, which is precisely when the board's patience runs out and somebody starts using the word copilot. 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'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 cost, right? That's it. 2 lines. It's computable from your own profit and loss statement, about 30 minutes. And the only reason it takes 30 and not 5 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, purchased 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 1, 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 numerator and also inside of your denominator, The ratio measures nothing. Strip it out. Okay. Trap 2, rebates and discounts that live below the gross margin line. We know 'em, we see 'em 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 rebates down in SG&A, your numerator's $14 million too generous. And your vertical be too kind. So pay attention to it. Let's get it up there. Trap 3, intercompany. That classic one. You got a little bigger organization. Left hand is selling to the right hand, right? From one pocket to the other. We do it all the time. If you got 'em 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 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 because they're temp, still got to go in there. Okay, trap number 1, direct labor buried in your COGS. Most controllers will hand you, will hand you an SG&A payroll number and stop. That's not the denominator. That's a third of the denominator. Trap 2, 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 cost. So don't strip them out regardless of where it's booked. Put them in the employee costs. I know you have them in there, can be an add 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 3, the PEO invoice. One line, one vendor, 60 people. Open it. Do those 2 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 4 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 intensity. A heavily automated manufacturer with a lot of machinery and 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 2.2 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 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 1 or 4, 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 2 tenths are going to cost me, because that's the real unit of work here, not the band you're in. The next 2 tenths. A company that moves from 1.4 to 1.7 and 3 quarters is doing better work. than a company sitting flat at 2.8, 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 2.1 that was at 1.8 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 There's a company and a problem that hasn't been named yet. And the fact it's sitting inside— and the fact that it's sitting 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 2 tracks. Once you have the number, you're on one of the 2 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 shares. 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 the work. Now, below that threshold, you're on the fix 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 here what the fix-first track actually is, because the CEOs hear it as penalty box, and it's the opposite. The fix-first track is the highest return work available to you in the entire 1,000 days. Nothing else you can do with that $4 million 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 $4 million? Spend it on segmentation, the pricing, and the complexity removal, and come back in 4 quarters with a number that lets you spend it on growth properly. All right, here's what moves the ratio. There's 3 things that do it in order of speed. First, price. No shocker there, huh? It's always the one. It's the 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. 2 to 4 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 2 quarters. That's significant. That's material. And that's a full episode by itself. And it's episode number 6. Next comes mix. It's slower. It's bigger. You retire tail revenue that carries low material margin and you redeploy the freed 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 2 stick. Now, what doesn't move it? Headcount cuts. You would think it would. Hey, I see it all the time. It means less employees. Well, guess what? Headcuts by itself Isn't gonna 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. $180 million business, material margin $63 million, 35%. Not too bad. Fully loaded employee costs, $28 million. 63 over 28, 2.25. Blows threshold. Time to fix it. Let's get on the fix it track. Now cut 10% of that workforce across the board. And the way it actually happens, a percentage handed down to every function so it feels fair. Employees' costs go from 28 to 25.2. Feeling 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 gonna bring those orders in and ship 'em? So call it 10%, which in my experience is generous to you. 63 becomes 56.7. Hmm. That 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 tail. So the 4 people who service the tail 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 gonna hire them back inside of a year at a premium, and that's gonna 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 1.5 points of realized price. On $180 million, that's $2.7 million. Essentially all of it straight to material margin. We love that. 63 goes to 65.7. Ratio 2.35. Looking better. Now, mix. Retire $7 million of tail revenue running 12% material margin. That costs you $840,000 of margin. And if you stop there, the ratio goes down. Not the way we want. Unintended consequence, which is the trap that makes people quit halfway. But if you freed capacity, redeploy it in Quad 1, the 4 segments running 41% material margin, $7 million is $2.8 million. $7 million there is $2.7 million. $7 million there is $2.87 million. That's a net of plus $2 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. 2 quarters later, you do it again and you're through 2.5 and you're on the other track. And now the $4 million for salespeople is a good idea instead of a fatal one. Know these numbers can get a lot at you, but if you just take them, 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 4 consecutive quarters of 2 moves each, which is exactly why so few people finish it. So what's the plan? It's 3 moves. The first one this week, move number 1, 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 1 hour, build the numerator. Revenue minus materials, purchased 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 COGS, 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 6 weeks and produces a number you don't trust because you didn't watch it get made. You want 2 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 1 year ago. Same definitions, same buckets, no adjustments needed. Now you have 2 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 you, 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 says. I've had CEOs come back to me delighted because they're at 2.8, comfortably inside of the healthy band. And then we pull last year and last year was 3.2 and the delight goes away quickly because a business shedding 0.4 a year is 18 months from the first fix-it track and nobody's even noticed. 2 dots, 1 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 2 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 4 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 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 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 4 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 and shaped. 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 100 days of earn the right to work is different. The first 100 days of the earn the right to work, and this is different clock than your first 100 days in the seat. This is phase 1 of phase 2. It has 9 deliverables. 9. And here they are. First, a segment-level profit and loss statement. Not a customer list or a revenue next to it. A P&L by segment with material margin and cost to serve. Second, every segment classified Quad 1 through Quad 4. 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 4 decision: exit, reprice, or starve. Write it down with a name against it. 5, do the Dirty Dozen kill list with at least 6 items actually retired. Not identified, retired. You got to get it done. Number 6, a zero-up rebuilt budget built from zero, not from last year's plus 5. We all know how that works. We're not trying to Stay the course. We're trying to build. 7th, a live X matrix with 5 to 7 priorities. 5 to 7. If there's 25 on it, go back and read episode 2. 8, live boulders, your KPI scorecard with countermeasures written against every red. 9, the first monthly business review run on the new system. The MBRs are powerful. It's going to track your KPIs. You'll figure out what's working. If you finished phase 1 without those 9 things, you didn't do phase 1. You just did orientation. Feels good. Not enough. That's the tale for theater, by the way. Theater has slides for the 9 deliverables should be. Theater has work stream charts with 11 swim lanes and a project management office. Theater's super busy. We've all seen it. We know what it looks and feels like. Working looks like this, a segmented P&L that a room can argue about. 6 things gone. 1 number on a whiteboard and a monthly meeting where variances get causes and countermeasures, not objectives. 3 things worth keeping. First, material margin divided by total fully loaded employee costs. Below 2.5, you're not earning the right to grow. 2.5 to 3.5 is a healthy middle market band. 4 is exceptional. You're a rock star. Calibrate the level to your industry's capital intensity and watch the direction of travel harder than 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 2 tenths. Not the whole band. Second, price mix and complexity removal move the ratio. Headcounts 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, 2 tracks. You have to declare one. Above threshold, fund the growth track plan. Below threshold, do not fund the growth plan. Do not add sales capacity. Spend the money on the engine and come back in 4 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, 8 salespeople, $4.1 million. He'll get to run it. He's going to run it about 6 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 pieces 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? 22 of them said no. That was the good news. If you want to run today's calculation, the worksheet is at the 80/20 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 Canady. Go run your numbers. Have a great day.

You've been listening to The 1,000 Day CEO with Bill Canady. Follow the show for more decisive leadership, sustainable growth, and strategies that build enduring businesses. Until next time, make every day count.