07/31/2013

Profit Improvement Report: Little Things Mean a Lot

By Dr. Albert D. Bates
President, Profit Planning Group

The last few years have been one of the most challenging periods ever in terms of consistently producing adequate profits. Managers had to operate in a period of sharp economic decline and pessimism, followed by several years of anemic growth. Only recently has the economic picture appeared to improve fundamentally. But even now, there is concern that things may not be as stable as they seem.

Interestingly, during the entire range of ups and downs, some firms produced much higher profit than the average firm during every year. It wasn't that the more successful firms were in easier market areas or enjoyed some unusual advantage that was unique to them.

Quite the contrary. The most successful firms did a very few things better than the typical firm. They also did them just a little bit better than average. In addition, they did them a little better every year. Over time they have built a strong financial advantage.

The 2013 NAHAD report (if you did not participate, it is now available for purchase in the NAHAD Store) provides some key insights into exactly how the high-profit firm generates those better profit numbers. It is essential for every firm to understand that the key is to do a few things just a little better. The report provides clear evidence as to how small differences in a few areas translate directly into higher levels of profitability.

Typical Versus High Profit
The typical firm in the survey is the firm with financial performance in the exact middle of the results for all participating firms. That is, on any given measure, half of the firms performed better than the typical firm and half performed worse. It is the best measure of industry performance on any of the profit drivers.

In 2012 the typical firm generated sales of $12,279,359. On that sales base, it produced a pre-tax profit of $564,851, which equates to a profit margin of 4.6% of sales. Stated somewhat differently, every $1.00 of sales resulted in 4.6 cents of profit. The results can best be described as adequate. Quite simply, they are not as strong as they should be.

In contrast to the typical firm, the high-profit firm generated a profit margin of 13.8%. This means that even if the high-profit firm had produced the same sales volume as the typical firm, it would have generated more profit for reinvestment in the firm. This additional asset base produces a multiplier effect over time. More profit leads to a strong asset base which supports more sales for even greater profit.

Luckily, high-profit performance is open to any firm willing to take proper action. There are no barriers to success in the industry. The only requirement is to identify the areas where the high-profit firms perform better and to target for that level of performance.

Managing the CPVs
To reach high-profit performance the firm has to focus on what really matters. In benchmarking terms, the important items are called the critical profit variables (CPVs). While the CPVs tend to remain the same over time, their relative importance tends to vary somewhat. The CPV results for the typical firm and high-profit firm in the industry are summarized in Exhibit 1.

Exhibit 1

The Critical Profit Variables

                                                                            Typical                 High Profit          

                Performance Results                                                     

                Net Sales                                             $12,279,359        $16,876,266       

                Profit Margin (pre-tax)                          4.6%                    13.8%   

                The Critical Profit Variables                                                         

                Sales Growth Change                          11.1%                  12.3%   

                Gross Margin                                       35.3%                   42.0%   

                Payroll Expense                                   21.7%                   20.4%   

                Non-Payroll Expenses                          8.7%                     7.4%     

To a certain extent, some of the differences on the CPVs between typical and high-profit may appear to be so small that they don't even deserve management attention. In fact, it is these small differences that multiply to produce major changes in profit margin. This means the typical firm doesn't have to dramatically improve performance on the CPVs, but simply do a little better across the board. As the title of this article stated, Little Things Mean a Lot.

From a management perspective, it is not even necessary to do a little better everywhere. No firm produces superior results for every single CPV in either good times or bad. Successful firms manage their CPV performance so as to maximize overall profitability. This also is great news for the typical firm. Perfection is not required, only blending the CPVs in a positive way.  With such blending, profit rises significantly.

The CPVs that are the most important to enhancing profit results are sales growth, gross margin, payroll expenses and non-payroll expenses. Each of the factors needs to be planned carefully to ensure adequate profits.

Sales Growth
The level of sales growth is always a key issue in generating adequate profits. However, there is a misunderstanding that very rapid sales growth is required for success. Nothing could be further from the truth.

The so-called ideal rate of sales growth equals the rate of inflation plus two to five percentage points. Consequently, if the inflation rate is 2%, then ideal sales growth would be in the 5% to 8% range. This should be viewed as a minimum. Firms may well grow faster, but without basic growth, profit improvement is very difficult.

Sales growth that is too slow means that expenses, which tend to be tied closely to inflation, out-pace the rate of growth so that expenses as a percent of sales increase. Sales growth that is too rapid is also a problem. Financing rapid growth is always a challenge, and operating systems tend to get taxed when growth is rapid.

The reality is that almost no firm will ever turn down a rapid rate of sales growth. However, firms should be aware that sales solve a lot of problems, but very rapid sales growth tends to create as many problems as it solves.

Again, the ideal level of sales growth is to beat the rate of inflation by somewhere between two to five percentage points. Firms should make such an effort a central part of their planning process.

Gross Margin
Price pressures never go away, even as the economy recovers. In a down market firms are too anxious to cut prices to hold sales volume. In an up market the euphoria over increasing sales tends to reduce the diligence that should be placed on pricing.

In almost every industry an adequate gross margin is a major determinant of profitability. The real driver behind improved, or at least maintained, gross margin performance is continual monitoring. The inevitable "one-time" deals must never become the norm of operations.

Payroll Expenses
Payroll is by far the most important expense factor, which means that controlling payroll is essential to controlling expenses. Payroll is another area where a specific improvement goal can be established. Ideally, payroll costs should increase by about 2% less than sales. For example, if sales increase by 5%, then payroll should only be allowed to increase by 3%.

This would appear to be a relatively simple, and probably easy to achieve, target. The reality is a different story. Payroll is the most difficult of all the CPVs to control. The 2% goal always proves difficult to achieve.

Non-Payroll Expenses
Most non-payroll expenses usually require only minor adjustment if sales really are rising faster than inflation. The lion’s share of non-payroll expenses is linked directly to inflation. Controlled growth should keep them in line.

Moving Forward
The high-profit firms produce great results virtually every year. They also reflect the fact that there are no industry barriers to success. The key to improved performance is to develop a specific plan for each of the CPVs and combine them in a positive way. The goal is not perfection. The goal is to do a little better across the board. Firms must remember the mantra of Little Things Mean a Lot.

About the Author:

Dr. Albert D. Bates is founder and president of Profit Planning Group. His latest book, Triple Your Profit!, is available at: www.tripleyourprofitbook.com, as well as Amazon and Barnes & Noble.

©2012 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.