Contrary to Popular Belief, Turnover and Onboarding Aren’t Simply Costs of Doing Business.
They Could Be Killing Your Net Income!
by Bill Albert
President, BMI Global Consulting
Your intuition tells you that there is a connection between high turnover rates and profitability. However, you’re not sure you can prove it. Your company just had a number of layoffs and they are telling you that there is a hiring freeze. Obviously there are financial concerns. You find yourself wondering if it is possible to calculate the impact that Turnover has on Net Income? If you find your asking yourself this question, we think the answer is yes, and in this article we will walk you through the process we considered to bring us to this conclusion.
What triggered the consideration…
We were having a conversation with the VP of Human Resources for a mid-sized manufacturing company. We were talking about her workforce, and she indicated that they annually had about a 23% turnover ratio. In easy-to-understand numbers, this would mean that If you had a company with 100 people in it, 23 of those people would be replaced with 23 new ones (potentially).
Imagine trying to run that business and having 23 of your people come and go in a year. That’s more than a fifth of your people. Think of the potential loss of organizational memory, costs, wasted time and productivity, and what that might mean to customer satisfaction (internal and external).
Her response surprised us. She said that people coming and going is normal and that this was just considered as ‘a part of running their business.’ As long as the work got done, everything was within reason and acceptable.
After the meeting my business partner and I believed this still seemed excessive. That meeting inspired a ‘what if’ conversation within our team to see if we could reasonably calculate the costs associated with a normal employee’s life cycle; from the initial onboarding to their ultimate separation. Was it possible to determine the financial impact that turnover has on earnings? So, we began by looking at a normal ‘employee life cycle’ within an organization.
What is the potential financial impact? Below was the original model we started with (using partial descriptors):
We looked at the life cycle of an employee from three perspectives:
• The Acquisition Phase
• The Ongoing Training & Development Phase (career with company)
• The Separation Phase (leaves, fired, retires, etc.)
We understood that there were both Direct and Indirect Costs associated with each of these three ‘phases’. Many of the costs associated with this employee life cycle are ‘Easy to identify because they are things we see’ every day. These are the costs above the waterline, as seen in the graphic below. But many direct and indirect costs are hidden below the waterline, which are those ‘Deeper Stuff’ costs that we normally don’t see or think about. But just because they are hidden doesn’t mean they don’t exist.
All of these costs, both above and below the waterline, have a financial impact on an organization.
A simple definition for Direct Costs (for our purposes here) are those costs that can be ‘directly allocated’ back to an individual employee or employee’s department. And for Indirect Costs, they are any costs that ‘cannot be directly attributed’ back to an individual or department but were spent because of multiple actions that were performed in support of the people. For example, if we are hiring a person for the IT Department, we could allocate a certain amount of the costs associated with hiring them back to that department. However, if we were training several new hires at one time, we probably can’t allocate all the costs of the trainer’s time, effort, etc. back to any one individual or department. These are more indirect.
The costs mentioned above include not only all those direct and indirect costs but also represents the amount of effort by others needed to help the individual throughout their ‘employee life cycle’ within the organization. When we add all those things together, it gives us an idea of the ‘positional replacement cost’ for that individual employee.
Our completed model looked like this:
After establishing the model, we started breaking the workforce down into three basic categories to test our theory:
- High-Level Executives
- Mid-Level Managers
We then assigned salary, benefits and training costs to each employment category.
- High-Level Executives $100,000
- Mid-Level Managers $ 50,000
- Entry-Level $ 25,000
Philosophically, we believe that every time a company makes a hiring decision, it needs to be viewed as an investment, regardless of level. The National Business Research Institute seems to agree. They published an article several years ago where they cited the results of a survey on hiring they had conducted. In it, they discovered that:
- 66% said that they had experienced negative effects of making a bad hire
- 37% of that group said that the bad hire had negatively affected employee morale
- 18% of that same group said the bad hire negatively impacted customer relationships
- 43% stated that bad hiring decisions were made as a result of needing to hire bodies to fill positions quickly
Sound familiar? This is why we began with the thought that every hire must be viewed as an investment. There are too many costs associated with the ‘hire’ to get it wrong.
We created a ‘hiring’ example to make our case.
A company determines that it is going to hire two Mid-Level Managers and at a salary of $50,000 each, and one High-Level Executive at a salary of $100,000. When we do this, what might the investment for these three potentially look like?
The graphic below captures the basic investments of the positional hires. Underneath the graphic is a detailed explanation.
- We took the first of the two managers and said their salary is 50K
- Benefit packages from 0.20% to 0.40% of salary. 10K to 20K
- Training and equipment to get them up to speed. 25K to 65K
A company could legitimately invest in a single Mid-Level manager between 85K and 135K. If you hired two at that level, it could be between $170K and $270K.
We applied the same principle to a high-level executive at 100K a year, their cost to the organization alone could be between 170K and 270K.
When combined, these three individuals (using this example) could cost an organization up to $540,000. That’s for just three people.
Suppose you got it wrong and had to start over again. It could be a loss of potentially $540,000 and that’s not counting the reinvestment of potentially another $540,000! Here’s the part that often goes unnoticed.
Organizations only have so much cash.
There’s only so much money. By tying up potentially $1,080,000 on hiring the right three employees, we took $1,080,000 that the organization could have potentially invested somewhere else; or at least the $540,000 we might not have needed to spend if we had gotten it right the first time.
For our purposes, we created a fictitious company valued at $200,000,000 and that had 200 employees. We then asked ourselves, “What would happen if thirteen (13) of our people turned over during the year. What would that mean financially to us? What would be the impact on earnings?”
We went back to our three employee level categories from above:
- High-Level Executives $100,000
- Mid-Level Managers $ 50,000
- Entry-Level $ 25,000
The we determined that of the 13 people we turned over,
- 10 were Entry-Level
- 2 were Mid-Level Managers
- 1 was a High-Level Executive
Our example looks at a 6.5% Turnover Rate
Here’s how to interpret the above graphic:
- 10 of the people were Entry-Level with a base salary of $25,000. When we include benefits and training, etc., and depending on the expertise needed for their position, the cost per employee could be between $42,500 and $67,500 (In this example). This means the aggregate cost of turnover and replacement for all ten combined could be between – $425K to $675K.
- Our 2 Mid-Level Managers (for example Managers, Directors, etc.) with a salary of $50K, benefits and training, etc. each had a value of somewhere between $85K and $135K. This means the aggregate cost of turnover and replacement for the two would be between – $170K to $270K
- Our 1 ‘High-Level Executive’ (Director, Vice President, etc.)’ with a salary of $100K, benefits and training, etc. had a value somewhere between $170K and $270K thus resulting in these turnover costs and replacement being between – $170K to $270K
Add all of these numbers up, and for only 13 people we have potential replacement costs between $765,000 and $1,215,000! The average of these two numbers is $990,000 … with just 13 people! That’s almost $1,000,000!
There are couple of things that stand out here and cannot be missed.
The combined salaries of the 13 employees equal $450,000. This will stay consistent when we hire their replacements.
What’s lost is all of the benefits, training and experience that we can’t get back. This is an irretrievable cost ranging between $365,000 to $765,000.
Why is this important to us? Why is it essential to our operational efficiencies and financial results? Let’s take an even closer look.
There is something that most companies look at to determine when they start actually making profit. They are called ‘break-even points’.
In its simplest definition, an organization’s financial break-even point occurs when its sales revenues and their operating expenses and cost of goods reach a point during for a year, and they are equal. Graphically it looked like this:
Companies don’t start making money until they are driving more profit than the costs it takes to make them.
Financially, Break-even looks like this:
While the formula may be important, it’s the story we want you to see. What you should notice is that this is a $200,000,000 organization in sales revenues. And, after subtracting their COGS (Cost of Goods), Fixed & Variable Expenses they have Net Income Dollars equaling $0. This tells us that the organization neither made money nor lost money. They simply ‘broke-even’.
Companies use this calculation (set to different performance parameters, etc.) to determine profitability and needed sales goals and margins to achieve desires earnings results.
If you remember, on page 7, we determined the average potential turnover cost was going to be $990,000 for those 13 people who came and went and part of our turnover. That’s pretty close to $1,000,000. So, what would happen if it a company gave away $1,000,000 in the price to their customers? This model works because what we want to consider is the negative impact that a $1,000,000 loss in price or loss in people is also $1,000,000 (instead of the $990,000 again on page 7) can have on the business. Companies always look at the impact that discounting has on profitability. Rarely is turnover calculated for its’ impact like this.
The graphic below demonstrates 6 major things that happen when our company discounts its’ price by even $1,000,000.
Here was the ‘operational and financial impact’ that a $1,000,000 loss had on our financial value. (This is also what happens when we start looking at turnover and replacement costs. The costs are just allocated in different places.)
- Your company is no longer $200,000,000. It’s now $199,000,000.
- Your Gross Margin is no longer $40,000,000. It’s now $39,000.
- That’s a loss of $1,000,000 in Net Income. That $1,000,000 in Cash lost
- And to break-even on our “$1,000,000’ price give-away (which reflects our ‘turnover and replacement costs and expenses), you have to sell an additional $6,761,317 in sales just to ‘break-even.’ Or before we should really replace our ’13 people’ who were part of our turnover.
- To support those additional needed sales (in this example), you need to spend an extra $5,432,099 in Cost of Goods (COGS) and additional variable expenses to support our $1,000,000 loss (turnover and replacement costs and expenses.)
Now, let’s look at number 6 and see what impact this has on our operational and financial results.
6. It’s here that the $6,761,317 in additional sales we need to ‘break-even’ reflects our “$1,000,000 in discounts or loss of sales we gave up and tells us from a leadership perspective what the impact all this has on the business. Look at it this way. Let’s say every invoice we process equals $1,000. In this scenario, we would have to process an additional 6,761 and potentially make an additional 6,761 deliveries just to break-even.
There are roughly 250 working days in a year. Our 6,761 additional invoices and deliveries would mean we would have to process an additional 27 orders a day to make enough money to break-even on our turnover and replacement costs. Do we even have the capacity and capability to do this and still provide an excellent customer experience?
That’s the reality and something we need to think of. The largest area of turnover and replacement for most companies is in their Entry-Level. Oddly enough, they are also the ones that are most responsible for delivering on the orders that our sales and project professionals close.
What is interesting then in ‘pulling this all together’ is as we mentioned earlier in the article
is that the $6,761,317 in additional sales we need to break-even reflects our $1,000,000 in discounts or loss in sales…
Now remember the potential replacement cost of average of $990,000… with just 13 people! That’s almost the same as the $1,000,000 in discounting or loss in sales. Something to think about.
This brings us a full circle concerning asking ourselves, if ‘turnover and replacement costs and expenses’ have an impact on the operational and financial results of our organization, especially our ‘net income? And the answer is ‘yes’! This is why it is so important that organizations invest in and develop solid talent management and workforce planning strategies.
As hard as this can be to explain, we tried to share in this article that one of the most critical success factors, regardless of a company’s size, is the ability to keep costs and expenses of doing business at a minimum. Each of us wants to ensure the best possible profit margins to sustain the growth and success of our organization into the future. However, what many of us may miss is that turnover and replacement costs can potentially be as devastating to the business as discounting and giving away margin. Both potentially represent a substantial operational and financial burden that could lead to the erosion of our net income.