Little Things Mean a Lot
By John Mackay
Why is it that one of every four material handling distributors makes three times more than the rest of the industry? Perhaps they have a great, well trained sales team executing a brilliant market plan. Or, have they found a market niche that the other three of four distributors hasn’t focused on yet?
Maybe the successful distributors did have a crack sales staff and maybe they did have a better marketing focus. But, there are no real solid benchmarks to back that up.
What there are concrete benchmarks for is that highly successful material handling distributors managed the details of their business just a little better, resulting in a lot better return on investment (ROI). Thriving distributors achieved their success by managing what the DiSC report calls the Critical Profit Variables (CPVs), see Exhibit 1. Those key CPVs are the decisive benchmarks that separate successful companies from other distributors in the industry.
Interestingly, the high-profit firms almost never truly excelled at any one of the CPVs. Instead, they were able to manage the collection of profit drivers just a “little bit” better than the typical company in the industry. This small delta in performance was enough to generate dramatically higher profit.
The MHEDA DiSC study provides some key insights into exactly how the high-profit firms generate better profit numbers. It focuses intently on the key profit drivers — growth, gross margin, expenses, inventory turnover and accounts receivable collections. The report provides a roadmap for any firm wanting to improve its financial performance.
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 MHEDA distributors. 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 2018 the typical firm generated sales of $40 million in revenue. On that sales base, it produced a pre-tax profit of $1.24 million, which equates to a profit margin of 3.1%. Stated somewhat differently, every $1.00 of sales resulted in 3.1¢ of profit.
In contrast to the typical firm, the “High Profit Firm” generated a profit margin of 6.9%. 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 company. Higher profit along with higher asset productivity ultimately resulted in higher return on equity to the owners of the business.
Managing the CPVs
In trying to move from typical to high-profit, the key is to understand the Critical Profit Variables with greater precision. To facilitate that understanding, 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 return on investment. This means that 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. However, being “good on everything” is not necessary to generate a high level of profitability. What is important is to be good on what counts.
It is important to emphasize once again that the CPVs that are the most important benchmarks to enhancing profit results are sales growth, gross margin, operating expenses (both payroll expenses and non-payroll expenses), and inventory turnover. Each factor 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. In fact, 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, resulting in lower profit.
While very few firms believe so, sales growth that is too rapid is also a problem. Cash flow in periods of rapid growth is always a challenge, and operating systems tend to get taxed when growth is too rapid.
• Gross Margin
Price pressures never go away. Yet, somehow the high-profit distributors were able to earn nearly 3 percentage points higher gross margin than the typical distributor in the industry. That is significant. However, they did not achieve this lucrative overall gross margin by simple charging 3% more for their products.
How did they earn such lofty margins? Through a combination of better product mix, emphasizing higher margin revenue categories, and by earning a slightly higher gross margin in each product category. Detailed benchmarks on product mix and gross margin by product category can be found in the DiSC report.
• Payroll Expenses & Employee Productivity
Payroll is always the largest operating expense factor a distributor faces, 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 the maximum increase in payroll should limited to 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 today’s 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.
It is interesting to note that high-profit distributors lowered their payroll expenses with improved employee productivity, not with lower salaries and wages. Again, detailed benchmarks on employee productivity can be found in the DiSC report.
• 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 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.
• Inventory Turnover
Bottom-line profit is not the only way to improve ROI. Asset Turnover is also a contributing factor. Asset Turnover measures how efficiently distributors are using the assets they have invested in. Inventory, in particular, is an important contributing factor for improving ROI. Inventory is important because it is approximately one-fourth of the total investment that a distributor has in the business and it is controllable, that is there is something that can be done to control or reduce this investment. Once again, more benchmarks on asset productivity are profiled in the DiSC report.
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. If one of four distributors in the industry can earn over 40% Return on Owner Equity, it should be a reasonable goal for the other three of four distributors in the same industry. Ultimately that is why MHEDA conducts the DiSC survey, to establish realistic, attainable profitability goals and determine the critical benchmarks for achieving those goals.