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

The short answer

Most CEOs try to grow before they have earned it, and the result is not growth — it is expansion. The business gets bigger, more complicated and less profitable at the same time, and the two look identical on the top line for about four quarters, which is exactly long enough to have hired against the wrong one.

There is a number that tells you which one you are about to do. It is the Right-to-Grow Ratio: material margin divided by total fully-loaded employee cost. Two lines off your own P&L, about thirty minutes, one verdict.

Read it against these bands:

• Below 2.5 — you have not earned the right to grow. Full stop.
• 2.5 to 3.5 — the typical healthy middle-market band, where a functioning industrial or distribution business ought to live.
• 4.0 — exceptional. If you are there, the question is why you are not pressing the accelerator harder.

Calibrate the level for your industry’s capital intensity — a services business at 2.2 can be perfectly healthy — and then watch the direction of travel harder than the level. A company that moved from 1.4 to 1.7 in three quarters is doing better work than one sitting flat at 2.8.

The number puts you on one of two tracks. Above threshold: fund the growth plan. Below threshold: do not fund the growth plan and do not add sales capacity. Spend the money on the engine instead. Price, mix and complexity removal move the ratio. Headcount cuts do not. A business that enters the hold at 1.6 and works price and mix hard typically crosses 2.0 in twelve to eighteen months.

What happens when you fund growth on a broken engine?

Day 116, a conference room in Ohio. The CEO has built a very good deck — thirty-one slides. It is a growth plan and it is not a stupid one: eight new sales heads, two branch openings, one new region, $4.1 million of investment, all of it paying back inside twenty-six months on his math. He has presented it to the board twice. He wants help sequencing the hires.

Instead: can somebody pull the P&L. Two lines come off it. It takes about half an hour, most of which is arguing with the controller about what belongs in which bucket. One number goes on the whiteboard.

1.6.

And the room goes quiet, because two of the four people in it already know what that number means, and they have known for a while, and nobody had said it out loud.

So it got said out loud. He was not going to hire eight salespeople. If he hired eight salespeople he would be a bigger, busier, 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.

Here is what the alternative looks like, and it is predictable enough that the memo could have been written in advance. The new sellers do their job. They sell. They sell what is easiest to sell, which is the tail, because the tail is where the discounting authority already exists and the competition is weakest. Revenue goes up seven or eight percent. Material margin percentage goes down. Operations absorbs a bunch of new order lines it was not 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.

Then there is the part that actually kills people: he would have burned eighteen months finding out. Eighteen months on a thousand-day clock. That is not a mistake you correct. That is a mistake you get replaced for, because you will be presenting the correction right around month twenty, which is precisely when the board’s patience runs out and somebody starts using the word “co-pilot.”

Why is “earn the right to grow” not a moral statement?

This phrase lands wrong in a lot of rooms. People hear it as you get only what you deserve — a lecture about not having suffered enough yet.

It is not that. It is a statement about probabilities.

A business below a certain operating threshold has a demonstrated, repeatable tendency to convert incremental revenue into incremental cost rather than incremental profit. That is not a character assessment. That is a machine with a known behavior. You would not put more fuel through an engine that is currently converting fuel into heat and noise. You would fix the engine. Same logic, no moralizing required.

The full principle is longer than the slogan and considerably 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.

Two tests. Can you take things away? And can you move people and money from where they are to where the profit actually is? If you cannot do either, you do not have a growth problem — you have a permission problem, and no amount of new revenue will fix it. It will only make the fix more expensive later.

And the reason it happens to good operators is not vanity. Growth is the thing they were hired for. Growth is the thing the board asks about. 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.

How do you calculate the Right-to-Grow Ratio?

Material margin divided by total fully-loaded employee cost.

Two lines. Computable from your own profit and loss statement in about thirty minutes — and the only reason it takes thirty and not five is that both lines are usually wrong the first time you pull them.

The numerator: material margin. 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 out to move product. That is it. Nothing else.

• Trap one, the big one: material margin is not gross margin. Your ERP has a field called gross margin and it is tempting and it is wrong for this purpose, because gross margin has direct labor absorbed into it, usually a slug of manufacturing overhead, and sometimes an allocation nobody currently employed at the company can explain. If labor is inside your numerator and inside your denominator, the ratio measures nothing. Strip it.
• Trap two: rebates and discounts filed below the gross margin line, under marketing or customer programs. Pull them up. That is not marketing. That is price. Leave fourteen million dollars of rebate down in SG&A and your numerator is fourteen million too generous — and your verdict will be too kind.
• Trap three: intercompany. If divisions are selling to each other, the transfer price is a decision somebody made, not a fact of nature. Eliminate it and use the outside cost.

The denominator: total fully-loaded employee cost. Everything you spend to have human beings. Fully loaded means fully loaded. Wages and salaries. Overtime. Bonus and commission accrual. Payroll taxes. Employer contributions to health, dental and retirement. Workers comp. Contract labor. Temp agencies. Leased employees under a PEO. And the direct labor sitting inside cost of goods sold, which you just stripped out of the numerator and which now belongs down here.

• Trap one: direct labor buried in COGS. Most controllers will hand you an SG&A payroll number and stop. That is not the denominator. That is a third of the denominator.
• Trap two: contractors hiding in professional services and outside services. If a person shows up Monday through Friday and does work an employee would otherwise do, that is employee cost, regardless of which line it is booked to. There are companies where eleven percent of the real workforce was invisible to the payroll report.
• Trap three: the PEO invoice. One line, one vendor, sixty people. Open it.

Do those two lines honestly and you have a number.

What do the bands mean, and why does direction beat level?

Below 2.5 — you have not earned the right to grow. Full stop. 2.5 to 3.5 — the typical healthy middle-market band, where a functioning industrial or distribution business ought to live. 4.0 — exceptional. If you are at four you are running an unusually clean engine, and the question is why you are not pressing the accelerator harder.

The caveat belongs in plain language rather than buried. The exact threshold varies by industry capital intensity. A heavily automated manufacturer with a lot of machinery and relatively few people will run structurally higher, because the machines are doing work that shows up in the numerator and not in the 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. Calibrate the level against your own industry. Thinking is required.

But here is the part almost nobody does. The direction of travel matters more than the level.

This number is not a grade. It is not a judgment on you, your team, or the business you inherited. It is a starting position — and there is no starting position on this scale that cannot be improved. None. The engine is always fixable. The only question is whether anybody 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 am starting from, and I know what the next two tenths cost me. Because that is the real unit of work here. Not the band you are in. The next two tenths.

A company that moves from 1.4 to 1.7 in three 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 is not. 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 worth funding. A company at 2.9 that was 3.3 a year ago has a problem it has not named yet — and the fact that it is sitting inside the healthy band is actively hiding it.

Level tells you where you are. Direction tells you what is happening to you.

What are the two tracks?

Once you have the number you are on one of two tracks, and you have to say which one out loud.

Above threshold — the grow track. Fund the growth plan. Add sales capacity. Go take share. You have an engine that converts revenue into profit, so the more revenue you push through it, the more profit comes out the other end. That is the whole reward for having done the work.

Below threshold — the fix-first track. The instruction here is blunt, so here it is blunt: do not fund the growth plan. Do not add sales capacity. Not “slow it down.” Not “phase it.” Do not fund it. Every dollar you put into demand generation on a broken engine comes back as cost.

But hear what the fix-first track actually is, because CEOs hear it as a penalty box and it is the opposite. The fix-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 are not being told to sit still. You are being told where the money actually is. You want that four million? Spend it on the segmentation, the pricing and the complexity removal, and come back in four quarters with a number that lets you spend it on growth properly.

What actually moves the ratio — and what only looks like it does?

Three things move it, in order of speed.

Price. The fastest lever you will ever touch, because it goes straight into the numerator with essentially nothing standing in front of it. Two to four points of realized price — 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 two quarters.

Mix. Slower, 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 sentence. Retiring alone does not do it.

Complexity removal. Slowest, most durable, and the one that makes the other two stick.

Now what does not move it: headcount cuts.

Every instinct says otherwise. The denominator is employee cost, so cut employees, the denominator drops, the ratio goes up. It is arithmetic.

It is not arithmetic. Here it is with real numbers.

A $180 million business. Material margin $63 million — thirty-five percent. Fully-loaded employee cost $28 million. Sixty-three over twenty-eight. 2.25. Below threshold, fix-first track.

Now cut ten percent of the workforce across the board, the way it actually happens — a percentage handed down to every function so it feels fair. Employee cost goes from $28 million to $25.2 million. That feels like picking up a couple of million dollars.

But the people you just cut were producing material margin. They were quoting, selling, servicing, engineering, expediting. Cut ten percent of the capability and material margin comes down with it — call it ten percent, which is generous to you. Sixty-three becomes $56.7 million.

$56.7 million over $25.2 million.

2.25.

You are exactly where you started. You have made the company smaller at the identical ratio, the remaining people are now doing the work of the people who are not there, and you have spent your one credible restructuring on nothing.

The ratio rewards capability, not thrift.

There is one exception and it is important. Cutting people who were attached to work you have actually stopped doing is completely different. That is not thrift — that is the second half of the principle: redeploying resources from low-value activity to high-value activity. You retired the tail, so the four people who serviced the tail move to the segments that pay, or they leave. That moves the ratio and it moves it permanently. The test is simple: did the work go away first, or did the people go away first? If the people went first, you are going to hire them back inside a year at a premium.

What does moving the ratio honestly look like?

Back to the $180 million business at 2.25. Here is the real path.

Price. A corridor cleanup delivers one and a half points of realized price. On $180 million that is $2.7 million, essentially all of it straight into material margin. Sixty-three goes to $65.7 million. Ratio: 2.35.

Mix. Retire $7 million of tail revenue running twelve percent material margin. That costs $840,000 of margin — and if you stop there, the ratio goes down, which is the trap that makes people quit halfway. But you freed capacity. Redeploy it into the Quad 1 segments running forty-one percent material margin. Seven million dollars there is $2.87 million. Net: plus $2 million.

$67.7 million over $28 million. 2.42.

Headcount: unchanged. Same $28 million. Different work.

Two quarters later you do it again, and you are through 2.5 and you are on the other track — and now the four million dollars for salespeople is a good idea instead of a fatal one.

That is what twelve to eighteen months looks like from the inside. It is not dramatic. It is four consecutive quarters of two moves each. Which is exactly why so few people finish it.

What are the three moves you can run this week?

Move one — calculate the ratio. Trailing twelve months. Not the budget, not the forecast, not the last quarter annualized — trailing twelve, because it is the only version nobody can argue with. Sit down with your CFO and your controller for one hour. Build the numerator: revenue minus materials, purchased components, subcontract, freight in and out, duty, royalties, rebates and cash discounts. Build the denominator: every dollar of human cost anywhere in the business, including direct labor in COGS, including contractors, including the PEO. Then divide.

One warning. Your finance team will want to build a model. Do not let them build a model. A model takes six weeks and produces a number you do not trust because you did not watch it get made. You want two numbers on a whiteboard in an hour, arrived at by argument, in front of you. The arguing is the point. That is where you find out that eleven percent of your workforce was invisible.

Move two — plot the direction of travel. Do it again for the same quarter one year ago. Same definitions, same buckets, no adjustments. Now you have two dots and a line between them. If the line is going up, do more of whatever you are doing, and be able to name what it is. If the line is flat, you are being carried by the market and you should assume the market will stop carrying you. If the line is going down, that is your emergency — and it is your emergency regardless of what the level says. CEOs come back delighted because they are at 2.8, comfortably inside the healthy band, and then last year turns out to have been 3.2, and the delight goes away, because a business shedding four tenths a year is eighteen months from the fix-first track and nobody has noticed. Two dots, one hour. That is the whole diagnostic.

Move three — declare a track, out loud, and stop funding the other one. This is the move people skip, and skipping it makes the first two decorative. You stand up in front of your leadership team, you say the number, 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 the number on the wall.

On the grow track: say it, fund it, and go. On the fix-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 headcount requisitions. The new branch. The trade show budget for a segment you are about to exit. The channel expansion.

And say why in the same breath, or your team will hear “we are not investing” and conclude you have lost your nerve. What you are actually saying is: we are investing all of it in the engine for four quarters, and then we are going to spend it on growth from a position where it works.

Earn the right. Then, and only then, accelerate.

What are the nine deliverables that prove you did the work?

“We’re working on it” is the most expensive sentence in the middle market. So the fix-first track has a defined shape and a checklist.

The first hundred days of the earn-the-right work — and this is a different clock than your first hundred days in the seat; this is Phase 1 of Phase Two — has nine deliverables:

1. A segment-level profit and loss statement. Not a customer list with revenue next to it. A P&L, by segment, with material margin and cost to serve.
2. Every segment classified Quad 1 through Quad 4.
3. The Right-to-Grow Ratio calculated, with direction of travel.
4. A documented Quad 4 decision — exit, reprice, or starve. Written down, with a name against it.
5. A Dirty Dozen kill list, with at least six items actually retired. Not identified. Retired.
6. A Zero-Up rebuilt budget. Built from zero, not from last year plus five.
7. A live X-Matrix with five to seven priorities. If there are twenty-five on it, go back and listen to Episode Two.
8. Live Bowlers — your KPI scorecards — with countermeasures written against every red.
9. The first monthly business review run on the new system.

If you finish Phase 1 without those nine things, you did not do Phase 1. You did orientation.

That is also the tell for theater. Theater has slides where the nine deliverables should be. Theater has a workstream chart with eleven swim lanes and a project management office. Theater is busy. Working looks like this: a segmented P&L 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 adjectives.

The through-line: profit first, then growth

Growth without profitability is not growth. It is acceleration into a wall. Profitable growth, in that order — profit first, then growth. Reverse them and you will be running harder every year, making less money, and wondering why.

The CEO in Ohio still has the deck. Thirty-one slides, eight salespeople, $4.1 million. He will get to run it — about six quarters later than he wanted to, out of a business that will actually convert it. And he is still in the seat, which is more than can be said for a lot of people who ran their version on schedule.

Frequently asked questions

What is the Right-to-Grow Ratio? It is material margin divided by total fully-loaded employee cost — two lines off your own profit and loss statement, computable in about thirty minutes. Material margin is revenue minus the truly variable third-party cost of what you sold. Fully-loaded employee cost is every dollar you spend to have human beings, including direct labor buried in cost of goods sold, contractors and PEO employees. The result tells you whether your business converts incremental revenue into incremental profit or into incremental cost.

What is a good Right-to-Grow Ratio? Below 2.5 you have not earned the right to grow. 2.5 to 3.5 is the typical healthy middle-market band, where a functioning industrial or distribution business ought to live. 4.0 is exceptional. The exact threshold varies by industry capital intensity: an automated manufacturer runs structurally higher, while a services or engineering-heavy business runs structurally lower, and 2.2 can be perfectly healthy there.

Why is material margin not the same as gross margin? Because gross margin has direct labor absorbed into it, usually a slug of manufacturing overhead, and sometimes an allocation nobody currently at the company can explain. If labor sits inside the numerator and also inside the denominator, the ratio measures nothing. Material margin strips labor out entirely — revenue minus materials, purchased components, subcontracted production, freight in and out, duty, royalties, rebates, cash discounts and co-op payments.

Do headcount cuts improve the ratio? No. Take a $180 million business with $63 million of material margin and $28 million of employee cost — a ratio of 2.25. Cut ten percent across the board and employee cost falls to $25.2 million, but the people cut were producing material margin, so it falls roughly ten percent too, to $56.7 million. The ratio is still 2.25. You get a smaller company with the identical problem and fewer people to fix it with. The ratio rewards capability, not thrift.

What actually moves the Right-to-Grow Ratio? Three things, in order of speed. Price is the fastest lever, because it goes straight into the numerator with essentially nothing in front of it — two to four points of realized price from a cleanup of exceptions and stale discounts is worth 0.1 to 0.3 on the ratio inside two quarters. Mix is slower and bigger: retire low-margin tail revenue and redeploy the freed capacity into high-margin segments. Complexity removal is slowest, most durable, and the one that makes the other two stick.

Why does the direction of travel matter more than the level? Because the level is a starting position, not a grade, and every business on the scale can move it. A company that goes from 1.4 to 1.7 in three quarters is doing better work than one sitting flat at 2.8, even though only one of them is inside the healthy band. Conversely, a company at 2.9 that was 3.3 a year ago has a problem it has not named yet, and sitting inside the healthy band is actively hiding it. Level tells you where you are; direction tells you what is happening to you.

How long does it take to cross the threshold? A business that enters the hold at 1.6 and works price and mix hard typically crosses 2.0 in twelve to eighteen months. That is the ordinary result, not the heroic one — four consecutive quarters of about two moves each, with headcount roughly unchanged. It is a project with a year and a half in it, not a quarter, which is exactly why so few operators finish it.

Find out whether your business has earned the right to grow.

The Profit Map calculator takes your segments and shows you where material margin actually lives, which quadrant each one sits in, and how much capacity your lowest-value revenue is consuming. It is the analysis behind the ratio — the thing that tells you what to retire and where to redeploy.

Run the Profit Map calculator

Related

• The 1,000-Day Framework — the full four-phase method
• The 80/20 Engine: Where Your Profit Actually Lives — the segmentation that feeds the ratio
• The Complexity Tax: Why 4% of Revenue Eats 30% of Capacity — the mix and complexity work

Full transcript

[00:01] A thousand 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 a CEO who has built me a very good deck. 31 slides. It’s a growth plan and it’s not a stupid one. Eight new sales heads, two branch openings, one 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 two lines of it, too. 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 it out loud. I told him he was not going to hire eight sales people. I told him that if he hired eight sales people, 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 had we had that going for us. Now, look, here’s the proof. The company ended the whole period at 1.6. 14 months later it crossed 2.0. Not by cutting people. Headcount was within

[02:02] 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 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 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 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 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 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 the growth meeting. Everybody’s feelings get hurt in a simplification meeting. So, here’s a 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

[04:02] 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 four quarters later, which is exactly long enough for you to hire 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 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 going to tell you right now, they’re not going to 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. Earning 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 calls 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

[06:02] 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 to what is getting this wrong in dollars and in days. Dollars first. Take the CEO in Ohio. 4.1 million of investment, eight sales people who each need something like 18 months to carry themselves. If he’d have hired them at 1.6, 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 head count goes up to cover, 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 $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 thousand-day clock. That’s not a mistake you correct. That’s the mistake you get replaced for because you will be presenting the correction right

[08:03] 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. It’s kind of just fun to do. But, what it is is material margin divided by total fully loaded employee cost, 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. Two lines. It’s 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 costs of the thing you sold. Materials, purchased components, subcontracted production, inbound freight, outbound freight, duty, royalty. And this one gets missed constantly, rebates, cash discounts, and co-op payments you pay to move the product. And that’s it, nothing else. Trap one, and it’s a big one, material 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 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

[10:03] customer programs. Pull them up. That’s not marketing, that’s price. If you leave $14 million of rebate down in SG&A, 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, 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 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 dog 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, leased employees under a PEO. And the direct labor sitting inside of cost of goods sold, which you just stripped out of the numerator and which now belongs down there. Okay, so you getting the idea. Just cuz they’re temps, still got to go in there. Okay, trap number one, direct labor buried in your COGS. Most controllers or how and you will hand you an SG&A 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 cost. So, don’t strip them out. Regardless of where it’s booked, put them in the employee cost. 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

[12:05] 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, don’t 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 intensive city. A heavily automated manufacture 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 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 that most 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

[14:05] 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 a 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 1.4 to 1.7 in three 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 expending 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 is a company in a problem that hasn’t been named yet, and the fact that in sitting 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 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 fixed first track. And on that track, the instruction is blunt. So, I’m going to be blunt. Do not fund

[16:06] 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 CEO’s here at this penalty box. 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 $4 million returns what fixing the engine returns because fixing the engine changes the yield on every dollar 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 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 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. Two, the four points of realized price, which is what a serious corridor cleans up. Which is what a serious corridor clean up delivers, not a general increase. A clean up 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. 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

[18:07] it’s the one that makes the other two stick. Now, what doesn’t move it? Headcount cuts. You would think it would. Hey, I’ve seen 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 cost, 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 $180 million business. Material margin $63 million, 35%. Not too bad. Fully loaded employee cost $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 cost go from 28 to 25.2. Feeling pretty good. We just picked up a couple million bucks. But the ploys 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

[20:08] important. Cutting people who were attached to work you have actually stopped doing is completely different. That’s not thrift. That’s the second half of the principle. Redeploy resources from low-value activity to high-value activity. You retire the tail, so the four 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 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 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 cost you 840,000 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 free capacity, redeploy and quad one, the fourth segment’s 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 net additive plus 2 million. We like those numbers. So you got to 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,

[22:10] 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 $4 million for sales people 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 four consecutive quarters of two moves each, which is exactly why so few people finish it. So what’s the plan? It’s three moves, the first one this week. Move number one, calculate the ratio. The take the trailing 12 months, no 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 cost in COGS including contractors including the P&L. Then divide. One warning, your finance team will want to build a model. Don’t let them build the models. It’s a waste of time. A model takes 6 weeks and produces a number you don’t trust because you didn’t you watch it get 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 1 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

[24:12] doing, do more of it. We like that. And be able to name what it is. If the line is flat, you’re carried 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 said. 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 it was 3.2 and the delight goes away quickly because a business shedding 4/10 a year is 18 months from the first fix it track and nobody’s even noticed. Two dots, 1 hour, that’s the whole diagnostic. Simple pimple, 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 decorated. You stand up in front of your leadership team and you say the number and you say what 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 spending commitments and stop the ones that are inconsistent with it. The sales has head counts requisitions, the sales head count requisitions, the new brands, 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 the phrase for it, earn the right, then and only then accelerate. What does it look like

[26:13] 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 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 one of phase two. It has nine deliverables, nine. 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 one through quad four. Third, the right to grow ratio calculated with direction of travel. Is it going up or down? Just got to look back. Fourth, a documented quad four decision. Exit, reprice, or star. 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 got to 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 25 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 MBR is a powerful. It’s going to track your KPI. You’ll figure out what’s working. If you finish phase one without those nine things, you didn’t do phase one. You just did orientation. Feels

[28:13] good, not enough. That’s the tail 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’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. Six things gone, one number on a whiteboard in a monthly meeting where variances get causes and countermeasures. Not objectives. Three things worth keeping. First, material margin divided by total fully loaded employee cost. Below 2.5, you not earn the right to grow. 2.5 to 3.5 is a healthy middle market band. Four is exceptional. You’re a rockstar. 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. You did good, good. Go faster. You’re not doing so great, get better. Every business on this scale can move it where 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. 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, 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

[30:16] 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 sales people, $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 four, your bottom value customers buying your bottom value products and the 12 pieces of complexity that hide in the 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.

EP04 — Earn the Right to Grow: The Two-Line Ratio and How to Move It