Incremental sales opportunities
Incremental sales volume is the great white whale of distribution management. This means that very few managers have actually seen it, but they have spent a lot of time, effort and even sorrow in the search. If they do find it, the results frequently are not what was anticipated.
Theoretically, incremental volume is additional sales that can be generated without incurring any increase in expenses. In practice, incremental volume is more often an increase in sales that can be achieved with only a modest increase in expenses.
Incremental volume is frequently expressed by the idea that if the delivery truck is going right by a potential customer, then the cost of making an additional stop is very low. Similarly, direct shipments are often viewed as situations where the firm only “has to sell and carry the accounts receivable for a little while.”
The problem with the incremental volume concept is that in the overwhelming majority of cases, the costs associated with servicing the sale tend to be underestimated. Further, the idea of a “cost-free” sale too often leads to serious margin erosions. The combination of higher-than-planned expenses and a low gross margin is almost always disastrous.
The Economics of Incremental Volume
Exhibit 1 looks at the economic impact of incremental volume, under present conditions and for three different scenarios. The first column presents the financial position of the typical MHEDA member as reported in the Distributor Performance Benchmarking Report. As can be seen, the firm has $10 million in sales, operates on a gross margin of 45% of sales, and produces a bottom line profit of $500,000 or 5% of sales.
|The Impact of Incremental Sales Volume
Under Different Expense and Margin Scenarios
|10% Incremental Sales Volume|
|Cost of Goods Sold||5,500,000||550,000||550,000||550,000|
|Profit Before Taxes||$500,000||$370,000||$114,000||-$24,000|
|Cost of Goods Sold||5,500,000||6,050,000||6,050,000||6,050,000|
|Profit Before Taxes||$500,000||$870,000||$614,000||$476,000|
The firm’s expenses have also been broken down into fixed and variable expenses. The variable expenses, such as commissions, overtime and bad debts, can be expected to increase directly with sales, even with incremental volume. These variable expenses have been estimated as being 8% of sales.
Fixed expenses, in contrast, are those that could normally be expected to remain constant as sales increase. These include a litany of factors, such as operating and administrative salaries, rent, utilities and depreciation.
The last three columns of numbers represent the impact of a 10% increase in sales under three different scenarios. In all three columns, the top half of the exhibit presents the results of the incremental volume by itself. The bottom half represents the overall impact on the firm with the incremental volume, margin and expenses added to the total.
Scenario One is a pure, theoretical, incremental approach. Sales are up by 10% with the same gross margin percentage as before. Of greatest consequence, fixed expenses do not increase at all. The profit impact is nothing short of spectacular. The only problem is that a 10% increase in sales is a large jump to have absolutely no associated increase in fixed expenses.
For very small amounts of incremental sales, the first scenario can prove appropriate, especially in the short run. However, when there is any significant amount of incremental volume—and 10% definitely qualifies as significant—the fixed expenses inevitably increase.
Scenario Two combines the 10% sales increase with an 8% increase in fixed expenses. The idea of sales rising faster than expenses is commonly called expense leveraging. The 2% level of expense leveraging in Scenario Two (10% sales increase, 8% increase in fixed expenses) represents good performance in most distribution firms. There is still a measurable improvement in profit, but it is much more modest.
Scenario Three represents the real problem with incremental volume—a mutation into price cutting. In this example, the incremental sales are achieved by lowering prices on the incremental sales by 15%. This means the incremental volume has a gross margin of only 35.3%, rather than 45.0%. The logic is that the fixed expenses have been covered, so the firm can lower its prices to generate the additional volume. However, when the price is reduced, even with expense leveraging, the profitability of the incremental sales effort is destroyed.
Controlling Incremental Sales
Exhibit 1 reflects the two things that management must continually focus on to ensure that incremental sales are really profitable. They are the two things that are seldom accounted for properly.
First, expense estimates associated with incremental sales should always be increased. This is because expenses are always under-estimated. Even for direct shipments, there is more than simply selling and collecting. There are always returns to handle, product functions to explain and myriad other costs. When costs are higher than planned, profits quickly drain away.
Second, it should be remembered that gross margin is king in distribution. Any program that requires a significant reduction in gross margin should be avoided. It is always tempting to assume that if expenses are low, then margins can be lowered and an adequate profit generated. For most firms, this is a myth.
There is another, highly strategic problem with low gross margins on incremental sales. As soon as one sale is made at a low margin, it is tempting to make a second, then a third. Ultimately, there is no stopping point on the slippery slope of gross margin reductions.
If managed properly, incremental sales volume can be an important profit driver for MHEDA members. The problem is that proper management is extremely difficult to maintain in the face of “pure add-on” sales volume. The larger the opportunity, the more difficult the situation is to control.
Firms must make sure that they properly assess the true expense relationships associated with incremental sales. Further, they must always be aware that gross margin is the single most important driver of profitability. When gross margin falls even a little, profit falls a lot.
|Meet the Author
Albert D. Bates, Ph.D., is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.