Guest editorial
By Dr. Albert D. Bates, Principal, Distribution Performance Project
This article was published in the February 2020 edition of NTEA News.
Setting priorities and determining areas of focus when improving profitability can be difficult, as seemingly everything is important. Almost every management team knows sales, gross margin and expenses are main profitability drivers, but there can be disagreement on the relative importance of each.
For example, the sales team is certain increased sales will easily lead to higher profit. While operations staff also want a sales increase, they may feel the key to higher profit is improved supply chain productivity. Other departments have different priorities, and uncertainty reigns.
Relative profit impact of CPVs
When setting priorities for the three critical profit variables (CPVs), first look objectively at the impact of each factor on bottom-line results. The chart above does so for the typical NTEA distributor member. Note, from the outset, it examines how profit might have been different during the current year under alternative scenarios.
As shown in the first column, the typical company generates $10 million in sales, operates on a gross margin of 22% of sales and produces bottom-line profit of 3% of sales or $300,000.
To understand the impact of making CPV changes, divide expenses into fixed and variable components. Fixed expenses are overhead costs that will not change during the year unless the firm takes a specific action to do so, such as hiring an additional office employee.
Variable expenses are those that will change automatically along with sales during the year. Items such as sales commissions and bad debts fall into this category, and they tend to be a relatively consistent percentage of sales.
Fixed expenses for the typical firm are estimated to be $1,500,000, and variable expenses are about 4% of sales.
The last three chart columns look at profit implications of a 2% improvement in sales, gross margin or total expenses. In each instance, the improvement factor is the same 2%.
For the sales increase, the first three lines on the income statement — sales, cost of goods sold and resulting gross margin — all increase by 2%, while fixed expenses remain the same. Variable expenses are still 4% of the sales volume. As a result, profit rises to $336,000 (a 12% increase).
In the middle column, gross margin dollars on sales rises by 2%. In the example, this is accomplished by lowering cost of goods sold (in essence, purchasing merchandise more economically). Both sales and expenses remain the same, and as a result, profit grows to $344,000 — a 14.7% increase.
In the last column, net sales, cost of goods sold and gross margin remain constant while fixed expenses are reduced by 2%. Variable expenses, which are more difficult to decrease, remain the same percent of sales. As a result, expense reduction drives up profit slightly less than a sales increase of the same magnitude. Specifically, profit jumps to $330,000 (a 10% gain).
This set of economics indicates a profit hierarchy of gross margin, followed by sales and expenses almost in tandem. The challenge is to integrate the three to increase profit in a way the whole firm can support
Integrating profit variables
A key to improving profitability can be to determine actions that enhance gross margin and control expenses without sacrificing sales volume. There are at least three ways a company could achieve this goal.
Problem account awareness
Enhanced analytical systems provide metrics to identify customers that are inherently unprofitable — typically combining low gross margins with high cost to serve. This combination is difficult to overcome, even if these customers account for massive sales volume.
While analysis is great, it does no good if there is no action. The entire company must be aware of the need to either generate a higher gross margin from these accounts or minimize associated service costs. Specific programs may be needed to implement the steps required to make challenging customers profitable. In some instances, this could involve raising prices.
Customer churn
The vast majority of customers are profitable — and a few are highly so. Unfortunately, every business faces turnover among good customers. Such churn not only reduces sales, it can lead to issues with expenses and gross margin.
The expense problem arises due to the inordinately high cost of finding new customers. The gross margin challenge occurs when firms are tempted by the presumed need to offer lower prices to attract new clients.
Churn can be avoided by continually interacting with customers to gauge satisfaction with the company’s pricing and service profile. When customers are lost, it’s important to understand why in order to help minimize future defections.
Pricing of slower-selling items
There could be a sales and gross margin opportunity. With these products, pricing concerns may be minimal as availability is the overwhelming value added.
To identify such opportunities, consider focusing on SKUs with both low sales level and low price. If identified, there is potential for modest sales volume increases and greater gross margin jumps — all without incurring additional expenses.
For more industry profitability resources, visit ntea.com/profitreport.