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An updated look at gross margin and payroll

Gross margin and payroll continually prove to be the factors most difficult to bring into line and the easiest to fall out of line. When things are slow, price pressures are inevitable. At the same time, sluggish or declining sales volume almost always results in an increase in payroll expense as a percentage of sales.

Measuring Performance
In a recession, individual performance measures often become temporarily distorted. Gross margin as a percent of sales might fall to extremely low levels. Further, it is usually not possible to reduce payroll as fast as sales fall, so payroll percentages rise sharply. While no ratio is perfect under such conditions, probably the most beneficial for measuring margin and payroll control in aggregate is the Personnel Productivity Ratio (PPR). The PPR is payroll (including all fringe benefits) expressed as a percentage of gross margin dollars.

Exhibit 1 provides a financial overview of a typical MHEDA member based upon the Distributor Statistical Comparison Report (DiSC Report). The first column in the exhibit provides current results in both dollars and as a percent of sales. The PPR calculation is also provided. This firm generates $16,500,000 in revenue and earns a pre-tax profit of $165,000, or 1.0 percent of sales. The keys to generating this level of results are a gross margin of 31.0 percent of sales and payroll expense of 18.0 percent of sales. These figures result in a PPR of 58.1 percent (payroll expenses of $2,970,000 divided by gross margin of $5,115,000). This means that for every dollar of gross margin that is generated, 58.1 cents must go to payroll. This leaves 41.9 cents to cover all other expenses and generate a profit.

Exhibit 1        

The Impact of a 1% Improvement in Gross Margin and
Payroll Expense For a Typical MHEDA Member

        1% Better
    1% More 1% Less on Both
Income Statement – $ Current Gross Margin Payroll Factors
Net Sales $16,500,000 $16,500,000 $16,500,000 $16,500,000
Cost of Goods Sold 11,385,000 11,333,850 11,385,000 11,333,850
Gross Margin 5,115,000 5,166,150 5,115,000 5,166,150
Payroll and Fringe Benefits    2,970,000 2,970,000 2,940,300 2,940,300
All Other Expenses  1,980,000 1,980,000 1,980,000 1,980,000
Total Expenses 4,950,000 4,950,000 4,920,300 4,920,300
Profit Before Taxes    $165,000 $216,150 $194,700 $245,850
Income Statement – %        
Net Sales 100.0 100.0 100.0 100.0
Cost of Goods Sold 69.0 68.7 69.0 68.7
Gross Margin 31.0 31.3 31.0 31.3
Payroll and Fringe Benefits 18.0 18.0 17.8 17.8
All Other Expenses 12.0 12.0 12.0 12.0
Total Expenses 30.0 30.0 29.8 29.8
Profit Before Taxes 1.0 1.3 1.2 1.5
Personnel Productivity Ratio 58.1% 57.5% 57.5% 56.9%
(Payroll as a Percent of Gross Margin)        

Almost all of the PPR guidelines bandied about are pure mythology. It is impossible to set an absolute goal without understanding the economics of the specific line of trade. The best way to set a goal is to examine the performance of the high-profit firm as reported in the DiSC Report.

Based upon this data set, a realistic PPR goal is approximately 48.5 percent. This means that the typical firm should be looking for a reduction in the range of 9.6 percentage points over time. The challenging issues, of course, are how quickly results can be improved and how to make the improvement.

Setting Gross Margin and Payroll Goals
Unfortunately, reducing the PPR by 9.6 percentage points is not an actionable objective. It is too difficult to understand exactly how improvements can be made. It is necessary to break the PPR into its two components—gross margin and payroll expense—and set individual goals for each of them.

Setting goals for these items is a company-specific undertaking. However, every firm should set goals that can be viewed as “bite-sized chunks” that can be readily achieved. A realistic starting point is to improve these factors by about 1.0 percent. Exhibit 1 reflects such a small, but meaningful, undertaking. For ease of understanding, the exhibit demonstrates the impact if sales for the firm remain constant. All the changes related to gross margin and payroll.

Gross Margin vs. Payroll

In Exhibit 1, a 1.0 percent increase in gross margin or a 1.0 percent decline in payroll expense had the same impact on the PPR. However, the margin improvement resulted in substantially higher profits. The superiority of gross margin becomes even more evident when more significant changes in performance are generated. While payroll control is important, gross margin control is paramount. This is illustrated by the following table, which tracks the percentage increase in dollar profits for the typical firm. As it makes improvements in either gross margin or payroll, dollar profit increases sharply if all other factors remain static. 

Percentage Increase in Dollar Profit from: 
Percentage Gross Payroll
Improvement Margin Costs
1.0 31.0 18.0
2.0 62.0 36.0
3.0 93.0 54.0
4.0 124.0 72.0
5.0 155.0 90.0

Specifically, in the second column, the firm generates 1.0 percent more margin dollars on the same sales. In the third column, the firm reduces its overall payroll burden by 1.0 percent, again with the same sales. The final column demonstrates the impact of making both changes at the same time.

Both actions cause the PPR to fall to 57.5 percent. However, since gross margin is a larger number than payroll, the improvement in margin has a larger impact on net profit before taxes than the improvement in payroll. Both are key drivers of performance, though.

Ideally, the firm can make both margin and payroll improvements at the same time. In the last column, the PPR falls to 56.9 percent. This is twice the impact of each of the changes being made separately. The entire intent of the exercise is to set some goals that everybody in the firm feels can be met, even in a period of economic challenges. The reality, though, is that goals are simply abstract ideas until a specific action plan for their achievement is put in place.

Gross Margin
In the current economic environment, substantial price increases are a pipe dream. However, firms continue to under-price their slowest-selling items and special-order merchandise. The improvement potential is more substantial than most firms believe. Slow economic times also create an opportunity to deal with problems that are ignored when everybody is too busy. Pricing errors are endemic to firms with lots of SKUs. Cleaning them up creates “free” gross margin dollars. Tighter control of shrinkage also represents a significant opportunity.

Payroll Expense
Most firms continue to believe that productivity improvements (better scheduling, automated warehousing, etc.) will solve the payroll challenge. Historically, productivity improvements have driven higher levels of sales per employee, but have done nothing to lower payroll costs as a percent of sales or to lower the PPR. Wages, health care premiums and the cost of other benefits have risen right along with sales per employee.

The key to payroll control is twofold. First, more attention must be given to order economics. The number of lines per order and the average line value must be increased. This is not really a productivity improvement—this actually results in doing less work. Second, the service profile of the firm needs to be examined. Most firms provide a lot of wonderful services and a few that nobody cares about. It is time to drop services that don’t enhance profitability.

Moving Forward
The never-ending economic challenges being experienced at present have taken as much of a psychological toll on employees as they have on profits. When the staff is tired and the future uncertain, improvement plans lose credibility.

This is a great time to set small improvement targets combined with strong implementation plans. The 1.0 percent goals identified here are one such opportunity. Over time, small improvements in the key drivers of profitability will generate significant improvements in the bottom line.

Material Handling Equipment Distributors Association
Al Bates Meet the Author
Albert D. Bates, Ph.D., is president of Profit Planning Group, located in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.

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