Rule of One-Third: An Intro

How To (Almost) Guarantee A Profit In Your Business

A reader asked me to clarify this rule on cost of labor in a professional service business.

Here’s the premise and how to use it.

The Rule of 1/3: A professional service business should not have TOTAL salaries exceed 33.33% of revenue.

Total salaries: includes contractors, employees, and management.

Product businesses should not exceed 1/4 of revenue.

Caveat: this is NOT an accounting rule. Your accountant will not have heard this rule. I created it as a fast guide to see how a service business is doing without needing to dive into P&Ls, Cash Flow Statement and Balance Sheet. I get into those things later with clients if it is necessary.

The Rule of 1/3 came about from noticing businesses that were struggling with profitability tended to have high payroll compared to their revenue.

I started to wonder, what percentage of payroll will make sure a business is profitable?

When I first started writing ads for businesses ages ago, a mentor told me I was pricing too low. He said that I should be charging a minimum of 3 times my hourly rate to actually make a profit.

He said this was because if I wanted to grow I would need to hire people at a market rate salary, which was what I was charging per hour at the time. After the cost of salaries, there is overhead — all the costs needed to actually run the business.

If I charged 3x market rate and paid 1/3 to the employee, I would have 2/3 left for running the company and profit.

How much profit do you want?

Most entrepreneurs don’t set profit targets.

With a professional service business, profits can exceed 33%. Most large firms have lower profits, sometimes around 10%. This is because they have high payroll, but they also have very high overhead. Mahogany paneled boardrooms in NYC don’t come cheap.

*** The Rule of 1/3 won’t guarantee you a profit as entrepreneurs can always find a place to spend money and not get a profitable return.

Was My Mentor Correct?

I followed his advice and I immediately started making more money. But it wasn’t until years later, when I started fixing my clients’ operational problems that I realized that, as a general guideline, he was right.

What I started doing was evaluating my clients’ business based on what money was left over after they paid all the people involved in their business. It seems across hundreds and hundreds of businesses I’ve worked with, that the Rule of 1/3 holds up.

All the companies that had low labor costs and small profits were spending too much money in overhead and not getting a return. Did you know if you buy a luxury car as your company car, that it also lowers your profit? Or if you fly your entire management team and their families to Hawaii for a week-long company retreat that it lowers your profitability?  That’s crazy, right?

However, most professional service companies had really high total labor costs and that’s why they weren’t very profitable.  They either took too large of a salary for themselves or they had an inefficient and ineffective team doing sub-optimal processes.

The solution may be to trim staff, but my first response is to look for efficiency increases in process improvement, task elimination, and 80/20 deliverable priorities.

I would rather retain qualified and trained people so that the company has the capacity to grow. If the company can’t grow fast enough so the team doesn’t remain idle for too long (that will create new, unprofitable, bad habits) then the company has to trim staff.

Feel free to ask how to use the Rule of 1/3 in your business.