Key Metrics: Correlations, Causations, and Necessity Part 2

Corey Adams

Diving into part 2 of the key metrics that I believe need to be understood, I wonder how many are still upset about the first one. The larger a company gets, the lower the quality delivered. I said it again, and I am sticking to it. It isn’t a bad thing if quality control keeps the delivered project above acceptable. It is the reality of size vs. oversight. 

The second key metric that goes into a growth strategy is margin. As a company grows, net margins begin to reduce. This could be considered a correlation, causation, and necessity all at once. But let’s dive into it a bit.

When we start out, most of us were a one-man band. We could land some smaller projects, maybe a few 5 figure ones, and really kick butt on the margin side. We were the ones doing 90% of the work and profiting at an extraordinary rate. It is not outrageous for a small company to push 40-50% margins for an entire year. We have low overhead, low payroll, and high owner involvement. In fact, most small companies average a net 30% profit margin. If they are doing $500,000 a year, they are raking in $150,000 in profit. Not too shabby for just starting out. 

As a company grows, those margins begin to shrink. We hire a crew, we have more equipment, we have office personnel, and our overhead costs like marketing and insurance go up. Why this is such a critical metric is it needs to be balanced. 

It really is nothing more than a simple math question. Would you rather have 25% of $1 million or 10% of $2 million? Now, these are random numbers for the sake of argument. I know quite a few companies doing $2 million at 25% and plenty of small companies doing 10% of $500,000. I also know companies that have a stated goal of 10% net profit on $5 million and some that are chasing 5% net on $50 million. We can always find a few outliers, but the reality is that profit margins are close to a linear function.

Why? A couple of reasons why growth often requires lower net margins. If you want to keep your margins at 30%, then branding and marketing will cost more. It requires a larger expense to attract and retain quality customers. This jump in the budget lowers margins. You may be able to offset it in the short run with higher prices, but in the end, it will eat away at some of those margins. 

Another reason is close percentages. Most larger companies work in highly competitive arenas. If you want to grow, you have to win more projects, and the unfortunate necessity of that is to lower your margins. 10% of a project is huge money to a general contractor when they are dealing with six figures. If those projects hit seven figures, it means everything.  I remember a story from a large masonry contractor where they won a multiple seven-figure contract by less than $25,000. It may seem small in the grand scheme, but I bet the other company kicked themselves for not winning it. 

To tie this in with part 1, lowering margins to grow and then lowering quality delivered because of growth runs the risk of a higher callback rate, back charges, and more. They play off each other, and both need to be accounted for in a growth plan.

Lowering margins is not the worst thing in the world. It does require some perspective. If you want to grow from $1 million to $2 million, it may be better to focus on current profit increases and not lowering margins to get your gross sales up. If you want to create an enterprise that goes to $10 million or more in gross sales, lower your margins to what is smart, competitive, and worth it. Companies that lower margins just to hover around the $2 million mark end up making less in the long run.  

I am not trying to discourage anyone from growing, quite the opposite. Growth is a great thing, but growth for the sake of growth is just regurgitated garbage from so-called business gurus or marketing companies that only have their growth in mind. 

Knowing where you want to be with margins and understanding that they resemble a linear function can help you design a strategy to grow your company where you feel comfortable. Tying it into the quality vs. size metric will make the strategy even clearer.