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The Sales-To-Payroll Delta

A critical planning tool for expense control

Payroll control is a critical issue for all MHEDA members. According to the latest Distributor Performance Benchmarking Report, payroll and associated fringe benefits account for 54.5 percent of total expenses. Payroll costs are 1.2 times as large as all other expenses combined.

One important challenge in controlling payroll is finding a practical procedure for planning what payroll costs should be. It is not enough to simply suggest that payroll should be a lower percentage of sales, as that does not suggest how much lower payroll costs should be or how fast a reduction can be made. Firms also face the very real issue that reducing payroll too much may diminish the firm’s ability to service its customer set effectively. Indeed, payroll costs can be too low as well as too high.

This report examines an approach for planning payroll called the “sales-to-payroll delta.”

Targeting the Sales-to-Payroll Delta
The sales-to-payroll delta is the difference in the growth rates of sales and total payroll costs, including fringe benefits. As an example, if sales grow by 5 percent and payroll costs grow by 3 percent, then the sales-to-payroll delta would be two percentage points. Similarly, with 15 percent sales growth and 13 percent payroll growth, there is still a delta of two percentage points.

The most important point regarding the sales-to-payroll delta is that it focuses management on the fact that sales do not have to grow rapidly to generate substantially higher profits. In each of the examples above, the firm produced a 2 percent sales-to-payroll delta. The plans are almost equally valuable.

The idea that actual sales growth may not be all that important is alien to traditional thinking, so it is useful to review Exhibit 1, which presents the latest financial results for the typical MHEDA member. As seen in the first column of numbers, this firm generates $25 million in sales volume, operates on a gross margin of 30 percent and produces a bottom-line profit of 2.5 percent. In addition, payroll and fringe benefits are 15 percent of sales, the largest expense category.

In the final two columns of numbers, sales have been increased. In the middle column the sales increase is only 5 percent, while in the final column it is 10 percent. The key issue is that in both examples, there is a 2 percent sales-to-payroll delta. That means that when sales increased by 5 percent, payroll only increased by 3 percent. By the same logic, the 10 percent sales increase has been supported by an 8 percent payroll increase.

It is important to note that in both examples, profit before taxes increased significantly. Of equal consequence, the 10 percent sales increase produced a profit improvement that was only modestly larger than the one generated by the 5 percent sales increase. This suggests that sales alone is not the driver of profitability. It is the firm’s ability to control payroll in relationship to sales that is key.

Percent of Sales or Percent of Gross Margin?
Payroll costs can be evaluated either as a percentage of sales or as a percentage of gross margin. The second approach is known as the Personnel Productivity Ratio, or PPR. The PPR for the typical MHEDA member is:

Payroll and Fringe Benefits / Gross Margin = $3,750,000 / $7,500,000 = 50%

Most managers are more comfortable thinking of payroll as a percentage of sales, simply because the approach has been used for so long. It also links payroll directly to sales generation. The PPR is more encompassing in that it is impacted by changes not only in sales and payroll costs, but also gross margin. While ultimately a useful ratio, it can be difficult to pinpoint exactly why improvements are taking place.

The results from Exhibit 1 may seem self-evident. Of course profit is increased when sales grow faster than payroll. The reality, though, is that while the results are self-evident, a measurable sales-to-payroll delta has proven to be an elusive goal for most MHEDA members.

Over the long term, sales and payroll tend to rise together. In tough economic times, firms tend to get aggressive on payroll. In good times, they tend to grow lax. The net result is that over a five-year period, sales and payroll tend to rise at the exact same rate. It is this pattern of equal increases that needs to be broken.

Setting a specific goal for the sales-to-payroll delta must be done at the individual firm level. For firms that have always had strong control of payroll expenses, a delta of only 1 percent or so per year may be all that is possible. For firms where payroll is somewhat out of control, a 3 percent improvement should be attainable. For the typical MHEDA firm, somewhere around 2 percent is a realistic goal for each of the next three to five years.

The goals may also need to vary depending upon economic conditions. As shown in Exhibit 1, with a 10 percent sales increase, it is relatively “easy” to produce a 2 percent sales-to-payroll delta. Payroll can increase by 8 percent, which allows for adequate increases in compensation for the existing work force and possibly even additional staffing.

In contrast, with only a 5 percent sales increase, the 3 percent increase in payroll requires a much more austere approach. Certainly, there is no latitude to increase compensation for some employees at all.

In a period of no sales growth, the 2 percent delta would require a reduction in payroll of 2 percent. At the most extreme, in a recession where sales fall by, say, 5 percent, achieving the goal of 2 percent would require a 7 percent reduction in payroll. Clearly, the slower the sales growth, the more difficult the 2 percent goal is to achieve. Even so, firms should target 2 percent as a realistic goal over time. For the next five years, a cumulative goal of 10 percent is desirable.

Making Specific Improvements
It is a lot easier to talk about making payroll improvements than it is to actually make them. All the sales-to-payroll delta can do is suggest the magnitude of the improvements that are needed to reach higher levels of profitability. The goals need to be translated into specific actions.

As noted earlier, generating a sales-to-payroll delta is much easier when sales are increasing. This means that the focus should be on creating an environment in which the firm generates modest sales growth continually. In essence, the firm must stop being captive to either market growth or prevailing economic conditions.

This conclusion leads back to a recurring theme in profit planning. MHEDA members must gain control over operating economics. This involves making significant improvements in three areas: •

  • Sales per Order Line — If the average line value on an invoice can be increased, then the firm generates more profit for the same level of expense.
  • Lines per Order — Working with customers to add one more line on every order creates more sales, but only a little more expense.
  • Fill Rate — When the firm is out of stock, a lot of effort is expended for no sales. A higher fill rate is always beneficial from a sales viewpoint.

Payroll is likely to be an issue for MHEDA members in perpetuity. Employees will always desire improved wages, and health insurance seems destined to increase at a significant rate. Firms must gain control over the payroll side, even in periods of modest sales growth. The sales-to-payroll delta is the most beneficial concept in planning for payroll control.

Material Handling Equipment Distributors Association
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.

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