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Profit Improvement Report ("Taking It To The Street" continued from page 38) is strategic or operational, it still has the same impact on profit. Namely, it decimates it. Unfortunately, too many managers continue to believe that passing along price decreases associated with opportunistic buying "doesn't cost us anything." Exhibit 1 The Impact of a 2.0% Reduction in Cost of Goods Sold For the Typical AED Member Income Statement--$ Net Sales Cost of Goods Sold Gross Margin Fixed Expenses Variable Expenses Total Expenses Profit Before Taxes Current Results $35,000,000 27,475,000 7,525,000 5,495,000 1,400,000 6,895,000 $630,000 -$122,500 100.0 76.9 23.1 15.7 4.0 19.7 3.4 100.0 78.5 21.5 16.0 4.0 20.0 1.5 87.2 100.0 78.5 21.5 15.7 4.0 19.7 1.8 2.0% Price Reduction 34,300,000 26,925,500 7,374,500 5,495,000 1,372,000 6,867,000 $507,500 $549,500 Change in Profit The Profit Income Statement--% Implications Net Sales An understanding of the Cost of Goods Sold economics of passing Gross Margin through price reductions Fixed Expenses Variable Expenses is provided by the CODB Total Expenses report conducted by Profit Before Taxes AED. Exhibit 1 examines Change in Profit--% the result for the typical AED member based upon that report. As can be seen in the first column of numbers, this typical firm generates $35,000,000 in sales, operates on a gross margin of 21.5 percent of sales and produces a bottom line profit of 1.8 percent of sales or $630,000. In short, profit performance is adequate, but somewhat unexciting. In looking at changes in pricing, it is necessary to break expenses out into their fixed and variable components. Fixed expenses are overhead items, or the cost of getting ready to sell. They only change when management takes an action. In contrast, variable expenses are items that increase or decrease at the same rate as sales increases or decreases. The most obvious example is sales commissions. Other variable items include interest on accounts receivable, bad debts and a few additional, incidental items. In most distribution businesses, fixed expenses account for about 80 percent of total operating expenses. In Exhibit 1, fixed expenses are assumed to be a constant $5,495,000 across modest increases or decreases in sales. Variable expenses are assumed to be 4 percent of revenue. The last two columns of numbers in Exhibit 1 present the potential results, both good and bad, associated with an opportunistic purchasing opportunity. To demonstrate the impact clearly, it is best to examine the total firm. The same results would be produced for a segment of the business. It is assumed that the firm is now able to buy everything that it sells at a price that is 2 percent lower than No Price Changes $35,000,000 26,925,500 8,074,500 5,495,000 1,400,000 6,895,000 $1,179,500 -19.4 before. As a result, the cost of goods sold had been reduced by 2 percent for the entire firm. This is true in both of the last two columns. The first column of potential results has been labeled No Price Changes. It really should be labeled Do This and Don't Even Think About Doing Anything Else. In this column the firm is using the supplier price reduction as an opportunity to enhance both its gross margin and its profit. All of the reduction in cost of goods has been driven to both the gross margin line and the bottom line. The resulting increase in profit is dramatic. Profit has increased from the $630,000 original figure to $1,179,500, an increase of 87.2 percent. The final column of numbers reflects the same opportunistic buying situation. However, prices outbound have been cut by 2 percent to mirror the 2 percent price reduction from suppliers. Again, this could occur either for strategic or operational reasons. But it makes no difference – profit takes a significant hit. While the gross margin percentage remains the same, the gross margin is being generated on sales, which have been lowered by the amount of the price reduction. Some expense reduction is attainable because of lower variable expenses, but fixed expenses hold constant. The overall result is that profit decreases by 19.4 percent, falling to $507,500. Whatever the good intentions of the reduction, profit suffers. Buying and pricing must be separate decisions. 40 | www.cedmag.com | Construction Equipment Distribution | September 2013 38_Bates_Profit_Feature_KP.indd 40 8/28/13 12:31 PM