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06/29/2011

Productivity is Only Part of the Answer

During the course of the last two decades distributors have made significant improvements in employee productivity. Sales per employee, the most widely-used measure of productivity, has advanced steadily. In large part, the increase is due to the application of new technology. However, this productivity surge has not resulted in lower payroll expenses, either as a percent of sales or as a percent of gross margin. When it comes to payroll control, distributors are in something of a rut.

The problem is not that technology does not lead to higher levels of employee productivity; it certainly does. The issue is that over time payroll growth tends to increase right along with sales growth regardless of the level of productivity. Every 5% increase in sales ultimately leads to a 5% increase in payroll costs.

This report will examine the nature of the rut and the possible paths for improvement in the future. It will do so by addressing two topics:

  • Payroll Sensitivity: An examination of how even small changes in payroll control can dramatically increase profitability.
  • Going Beyond Productivity: Suggestions on how payroll control can be enhanced by means other than productivity gains.

Payroll Sensitivity
The very good news is that major improvements in payroll performance are not required. Even very small improvements result in dramatic improvements in bottom-line performance. An analysis of this reality is presented in Exhibit 1.

The first column of numbers in the exhibit reviews the performance of the typical NAHAD member based upon the latest IPR report. As can be seen, the typical firm has sales of around $7,500,000 at a gross margin of 38.0%. This produces a pre-tax profit of $187,500 or 2.5% of sales.

Expenses are heavily weighted towards payroll. Of the $2,662,500 in total expenses, 66.2%of them are payroll and fringe benefits, or $1,762,500. Clearly, controlling payroll is one of the keys to enhanced profitability.

The last three represent three different assumptions about sales and payroll growth. In all three instances sales volume has increased by 5.0%. The only differences in any of the columns is the change in payroll expense.

In the Negative Delta column payroll expense (including both salaries and fringe benefits) has increased by 6.0%. This means it has grown 1.0% faster than sales have grown. The difference is so small, it would almost seem irrelevant. However, the profit implication is large.

Under the Negative Delta scenario, profit actually decreased by 4.4%. This is the classic case of selling more and enjoying it a lot less. Clearly, following this path is not an option. However, given that the delta between sales and payroll growth is so small, it is a path many firms will follow.

In the Productivity Parity column payroll and fringe benefits have increased by 5.0%, right along with sales. As noted earlier, this tends to be what happens for NAHAD members over the long run.

Even with Productivity Parity profit increases only as fast as sales growth. If profits are good, they remain good. If they are inadequate, they remain inadequate. Nothing really changes within the firm. The firm is not leveraging its sales growth in any way.

Finally, in the Positive Delta column payroll has only increased by 4.0%. The firm has been able to generate a 1% improvement in payroll effectiveness. Seemingly, not a difference worth discussing.

Only in the Positive Delta column do things get better. Payroll as a percent of sales begins to decline, albeit slowly. At the same time, profit increases by a full 14.4%, even though sales only increased by 5.0%. If this can be done systematically for three, four or five years, the entire character of the firm can be changed.

If it were easy to do, of course, every firm would do it. The very real problem is that generating sales growth beyond the level of payroll growth is a very difficult undertaking. It requires rethinking the workload.

Going Beyond Productivity
Continuing to improve employee productivity is essential for success. However, simply improving productivity is not enough. Something else must be added to the mix. In simplest terms, productivity involves increasing the speed with which work is completed. The additional approach simply involves doing less work.

Doing less work sounds like it should be easy. In reality, doing less is actually quite difficult. It necessitates a complete rethinking of what is important within the firm.

There are three attack points in the effort. First, completely marginal accounts that eat up a disproportionate share of the firm's payroll costs can be eliminated. This involves only a very few accounts, but has major cost implications. 

Almost every customer profitability analysis ever conducted concludes that something close to 40% of all customers are serviced at a loss. The thought of eliminating even one account is an anathema to most managers. For the very bottom rung of customers (typically 2% of the customers) there is simply no way they can ever be serviced at a profit. Doing less actually means doing nothing for this very small group of accounts.

Second, order economics have to be changed. Even among profitable accounts there are too many small orders. Minimum order standards have to be reviewed and enforced with greater vigor. In addition, order size needs to be carefully reviewed across different customers and different sales reps. The differences in order size within the same industry are enormous. Inevitably, those firms with a meaningful minimum order standard that is fairly enforced generate higher profits than those that have no standard or enforce it randomly.

Finally, the firm's service profile should be reviewed periodically. In the rush to gain volume too many firms have added services that few, if any, customers actually appreciate. Those services that generate expense without revenue should be eliminated. Research continually demonstrates that customers don't really want more services. They want basic services performed better. They want a better in-stock position and greater order accuracy. Interestingly, doing these better would actually lower payroll costs. No reorder processing, no error correction.

Moving Forward
Payroll expense has always been important. It has always been a topic of management concern. Unfortunately, it has always been approached as an area where new and better systems will save the day. They haven't done so in the past; they are unlikely to do so in the future. 

It is time to think strategically about actually reducing the workload. It is not a glamorous area of endeavor. It is one where there are significant profit opportunities, though. Working less is just as good as working faster.

A Managerial Sidebar: Combining Gross Margin and Payroll
The two big drivers of profitability for NAHAD members are payroll and gross margin. Each of these is usually examined in isolation. For NAHAD members payroll is 23.5% of sales and sales per employee is $299,921. Both figures need to be monitored on an on-going basis.

At the same time, the gross margin percentage for the typical NAHAD member is 38.0%. Again, this requires constant monitoring as even small changes have a very large impact on the bottom line.

In some instances it is useful to combine gross margin and payroll performance into a single measure. That measure is the Personnel Productivity Ratio (PPR) which expresses payroll costs as a percent of gross margin dollars.

For NAHAD members the figure is 61.8%. That means that 61.8 cents of every gross margin dollar must go to payroll. The remaining 38.2 cents of each margin dollar is available to cover all other expenses and contribute to profit.

The advantage of the PPR is it allows the firm to monitor decisions that may impact both gross margin and payroll simultaneously. For example, firms may move into service categories which have high margin, but require higher payroll. The PPR provides a measuring tool for such actions.

About the Author:
Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

Copyright 2011 Profit Planning Group. NAHAD has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.


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