Takeaways from MHEDA’s DiSC Report
By Al Bates
Every analysis of distributor profitability comes to the same conclusions: Three key factors drive profitability. Those factors are (1) the ability to increase sales a little faster than inflation, (2) the ability to maintain an adequate gross margin in the face of competitive pressures and (3) maintaining control of expenses, especially payroll, despite an upward trend in expenses associated with an improved economy.
The reality is that very few companies generate outstanding performance in all three of these areas. In general, most of the more-profitable firms manage the profit drivers just a “little bit” better than the typical firm in the industry. This small delta in performance is enough to generate dramatically higher profit.
The MHEDA financial benchmarking study provides some key insights into exactly how the high-profit firms generate better profit numbers. It focuses intently on the three profit drivers—growth, gross margin and expenses. The report provides clear evidence as to how small differences in those few areas translate directly into higher levels of profitability.
Typical Versus High Profit
The term “Typical Firm” in the report means the firm that is most representative of the industry. This typical firm is the one 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 the profit drivers.
In 2014 the typical firm generated sales of $35,660,000. On that sales base, it produced a pre-tax profit of $1,069,800, which equates to a profit margin of 3.0% of sales. Stated somewhat differently, every $1.00 of sales resulted in 3.0 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 6.2%. 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. It is a reinvestment factor that tends to multiply over time.
In trying to move from typical to high-profit, the key is to understand the nature of what are commonly called the Critical Profit Variables or the CPVs. Namely, which factors are most important and how do they impact performance for the typical and high-profit firms.
Managing the CPVs
The CPV results for the typical firm and high-profit firm in the industry are summarized in Exhibit 1. While there are other factors that could be examined in evaluating performance, these are the ones that really drive performance.
At first glance, some of the differences in 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 combine 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. There is a multiplier impact when performance is better in a few areas, even if “better” is relatively small.
From a management perspective, it is not even necessary to do a little better everywhere. Statistically, only about five firms out of a hundred out-perform the industry on all of the CPVs. However, being “good on everything” is not necessary to generate a high level of profitability.
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.
It is important to emphasize once again that the CPVs that are the most important to enhancing profit results are sales growth, gross margin and total operating expenses (both 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. It is especially important to emphasize that it is not necessary to achieve dramatic sales growth, just a growth rate that results in improved profitability.
The minimum rate of sales growth that a firm should plan for equals the rate of inflation plus three percentage points. Consequently, if the inflation rate is 2.0%, then ideal sales growth would be at least 5.0%. Again, this should be viewed as a minimum. Growth faster than 5.0% will help improve profits a little. Growth less than 5.0% will almost never lead to higher profit.
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. While very few firms believe so, 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 too 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 growth solves a lot of problems, but very rapid sales growth tends to create as many as it solves.
Again, the ideal level of sales growth is to beat the rate of inflation by somewhere around three 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. It would seem that as sales growth takes hold, firms would enjoy a pricing advantage. The reality is just the opposite. The excitement associated with increasing sales tends to cause firms to become lax with regard to pricing control.
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. There is no firm in any industry that could not make a modest improvement in gross margin.
• Payroll Expenses
Payroll is always the largest 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 2.0% less than sales. For example, if sales increase by 5.0%, then payroll should only be allowed to increase by 3.0%.
At first glance, controlling payroll growth would appear to be a relatively simple, and probably easy, to achieve target. The reality is a different story. Controlling payroll becomes even more difficult in a growth market. Firms often hire in expectation of even more sales growth. In addition, as labor markets tighten, employee retention becomes a larger concern and payroll has the potential to get out of control.
• Non-Payroll Expenses
The non-payroll expenses are the “least difficult” of expenses to control. Most of these expenses can be brought into line as long as sales really are rising faster than inflation. The vast majority of these expenses are directly related to the rate of inflation. As long as sales growth is maintained above the inflation rate, there is the potential to lower the non-payroll expense percentage.
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. It is an opportunity that is open to every firm.