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Back To The Future

Most firms have put the bleeding of the recession behind them. While profitability is still not back to desirable levels, things are clearly improving. The operative phrase in most instances is “cautiously optimistic.”

If sales, margin and expenses follow the pattern of previous recessions, most firms will be okay by the end of the year. The typical MHEDA member will be far removed from the massive challenges of the past two years. On the other hand, they may be equally far removed from optimal profitability. The challenge is that in the euphoria of getting back to good, many firms will miss the opportunity to make it all the way to great.

Business as Usual
The first column of numbers in Exhibit 1 provides a projection of overall financial results for the typical MHEDA member in 2011. Clearly, there is a lot of 2011 left and a lot of uncertainty still in the economy. However, it is possible to make a reasonable assumption about how the year will end up given (1) current sales trends and (2) an analysis of performance following previous recessions.

Exhibit 1
The Impact on Profit of Greater Control of the CPVs
For the Typical MHEDA Member
                 
    Projected   Margin   Payroll   Both Margin
Income Statement   Results   Control   Control   and Payroll
Net Sales   $25,000,000   $25,150,000   $25,000,000   $25,150,000
Cost of Goods Sold   17,500,000   17,500,000   17,500,000   17,500,000
Gross Margin   7,500,000   7,650,000   7,500,000   7,650,000
Payroll and Fringe Benefits 4,125,000   4,125,000   4,042,500   4,042,500
All Other Expenses   2,875,000   2,875,000   2,875,000   2,875,000
Total Expenses   7,000,000   7,000,000   6,917,500   6,917,500
Profit Before Taxes   $500,000   $650,000   $582,500   $732,500
                 
Increase in Profit–%       30.0%   16.5%   46.5%

 

As can be seen, the typical firm is anticipated to have sales of around $25 million at a gross margin of 30.0%. This should produce a pre-tax profit of $500,000, or 2.0% of sales. This is adequate performance, but not outstanding.

This means the profit results for the typical firm are expected to look a lot like they did before the recession hit. The reality, though, is that the pre-recession numbers were somewhat unexciting. Certainly, they are better than the depressed results seen during the depths of the recession. However, they do not represent the profitability that firms deserve.

It can be argued that the long-term profit results for MHEDA members are in something of a rut. Actual results rise and fall in tandem with economic conditions. However, across the business cycle, results always revert back to the norm. That norm has been in place for an agonizingly long time.

Interestingly, profit levels have remained somewhat constant despite the fact that firms in all industries, including MHEDA, have become more sophisticated. For example, 20 years ago, most inventory control systems were run on index cards. Today, most firms have sophisticated inventory management systems.

Increased sophistication has not led to better results for one reason. Firms continue to make the same mistakes at the same exact points in the business cycle over and over. This is not a criticism of management. Instead, it is an inevitable aspect of human behavior.

However, improving profitability—now or at any other point in time—must involve overcoming those normal behavioral tendencies. Management must overcome the pressures that lead to business as usual.

Making the Future Better
The remainder of Exhibit 1 examines how the firm could produce even more profit in 2011 by better managing the Critical Profit Variables (CPVs). These are the factors that have the most power to drive profit in the firm. The three most important are sales, gross margin and expenses.

Every firm is already managing the CPVs as effectively as they can, of course. The reality is that in the recovery phase of the economic cycle, firms look at the CPVs in a very different light than they do in the down phase of the cycle. This change in perspective limits the profit potential associated with recovery.

Setting a Profit Goal

Probably the oldest concept in all of financial planning is that small changes in the Critical Profit Variables (CPVs) cause profit to increase. Despite the fact that the concept is ancient, it is often overlooked in a period of economic recovery.

The following chart indicates how much dollar profit would be increased for the typical MHEDA member if each of the following four items were increased by one percent. That is, if prices were increased by 1.0%, items were purchased at a cost that was one percent lower and the like.

The figures provide some useful insights into how firms can use these small improvements to make profits even greater than they would be otherwise.

Area of 1% Improvement Percentage Increase in Dollar Profits
Pricing 47.2
Buying 35.0
Net Sales 12.2
Payroll Expense 8.3

As markets stabilize following a sharp recession two things inevitably occur. First, expenses demonstrate a relentless tendency to increase. More infrastructure is needed, employees need wage increases to “catch up” and the like. Second, pricing challenges arise. This is because the excitement inherent in sales increases automatically reduces the attention paid to pricing that is essential for desired profit performance.

It is important to note that these pressures have already been accounted for in the first column of numbers in the exhibit. That is, the exhibit assumes that human beings will continue to act as human beings. Not so much a failing as a reality of life.

The remaining columns examine the impact of maintaining greater diligence in the face of the sheer relief that the recession has ended. The two areas of focus explored in the exhibit are pricing and employee compensation. In both areas, a 2.0% improvement factor is used.

The 2.0% figure is not arbitrary. The better-performing firms across a wide range of industries tend to do about 2.0% better than the typical firm each year. The 2.0% differences add up to a dramatic improvement in overall profitability.

Pricing remains the Achilles’ heel of every recovery. As sales rise due to improving economic conditions, there is a natural tendency to want to recover sales volume at an even faster pace. This invariably leads to a diminished level of price monitoring.

In the Margin Control column in Exhibit 1, the firm generates 2.0% more gross margin dollars. The cost of goods remains constant, so the entire 2.0% increase is the result of improved pricing. The net effect is that profit increases by 30.0%.

The Payroll Control column reflects the human tendency towards fairness. When sales growth returns, the pressures on payroll become enormous. Employees naturally want a share of the good times just as they shared in the pain of the down market. If the payroll increase can be moderated so that it is 2.0% less than might otherwise occur, profit would increase by 16.5%. Sharing is fine, controlled sharing is much better.

The real payoff, of course, comes from doing both things simultaneously. The final column of numbers demonstrates how the firm would look if both gross margin and payroll were controlled more systematically. The 46.5% improvement changes the entire profit profile of the firm.

Moving Forward
After a brutal economic recession, there is a tendency to dramatically underperform compared to the potential profit that could be generated. There are two serious challenges that must be overcome. First, the firm should think in terms of producing a strong profit increase rather than accepting any improvement as being good enough. Second, the firm must be on guard for the factors that eat up the profit improvement that comes with higher sales. The firm must be especially mindful of ill-conceived expense increases and price reductions.

Albert D. Bates, Ph.D. 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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