The surprising factors that influence profitability – labour

In the first article in this series I introduced a model that implicated five rarely considered factors in the profitability of commercial organisations. While strategies to increase profitability usually include increasing prices and productivity or reducing costs and waste, the model shows that working capital, number of employees, share capital, share funds and total fixed assets explain a significant amount of the variability in the profitability of companies regardless of sector, monopolisation or market conditions.

The idea that operational managers hold more tools to improve profit may lead to a bias that they have the responsibility much more than executives. However, the model suggests that executive decisions could impede operational efforts to increase profits. On the other hand, carefully considered strategies to manage the variables implicated by the model could enhance operational efforts.

In the second article we looked more closely at one of these variables, working capital, and found that increasing working capital decreases profitability. While the effect was small in percentage terms (3.3 pence in the pound), it has the potential to explain as much as 40% of the disparity in profitability between companies.

In this, the third article in the series, we will look at the second variable in the model: number of employees. This is the second of the more obviously operational variables in the model. Before examining the results of the modelling, we must bear in mind that the data set used to develop the model was selected within a relatively narrow range of employee numbers, 200 – 250, and so the results and interpretation may only hold true within this narrow range.

Money Currency Income Investment  - jconejo / Pixabay
jconejo / Pixabay

The modelling shows that within this range, adding an extra employee to the workforce correlates with a decreased pre-tax profit of £37,557. At first glance, this relates to 1.4 times the average salary of an employee in the UK. It is widely accepted that employing someone costs more than their salary once payroll, pension, benefits, training costs, infrastructure costs, etc. are considered. However, assuming that adding an employee to the workforce increases the capacity of the company to create profit, the model implies that the expenses are much greater still and on average, far out-weigh the profit-creating capacity of adding an employee to a large SME. The model suggests in fact that adding more staff to a company of 200-250 people does little more than bloat the organisation.

One of the challenges for companies of this size is that they often introduce productivity-enhancing innovations, justified on paper with a reduction in the requirements for headcount. Unfortunately, what then often happens is that the headcount is not reduced. In which case the one off development cost and often the ongoing maintenance of the introduced technology adds to the overhead of the company without any of the promised cost savings having been realised.

Another challenge is that companies of this size (and somewhat smaller) may need to add non-revenue (and non-profit) generating staff in order to deal with growing administrative needs associated with, for example, human resource management, corporate governance and CSR. This may be tolerable if is developing infrastructure in preparation for subsequent growth. It may also be tolerable if the company is highly profitable and adding employees is designed to improve customer service, employee engagement or triple-bottom line management.

However, the financial bottom-line is that, for companies of this size, adding employees should not be done lightly. It is a decision that should be made strategically as well as operationally. And it is a decision that should be followed through to its conclusion – as in the case of productivity enhancing innovation resulting in cost-savings through job losses.

Whether, and how, this finding relates to smaller and larger companies remains an open question for further research. However, the interpretation points to some of the considerations that should be made, regardless of the size of the company.

In the next article we will turn our attention to the third variable in the model and the first that might be considered to be unilaterally influenced by executive decisions: total fixed assets.