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Profit Improvement Report As a starting point, the typical firm generates $35 million in sales volume. It operates on a gross margin 5.0% Vendor Price Increase Dollar Percent percentage of 21.5 percent Pass Through Pass Through of sales. Finally, it produces $36,373,750 $36,750,000 a pretax profit of $630,000 28,848,750 28,848,750 or 1.8 percent of sales. 7,525,000 7,901,250 In order to fully understand the economic impact 5,145,000 5,145,000 of price changes, it is first 1,837,500 1,818,688 6,963,688 6,982,500 necessary to break expenses $561,313 $918,750 down into two components – fixed expenses and variable expenses. Fixed expenses 100.0 100.0 78.5 79.3 remain constant for this 20.7 21.5 fiscal year, unless the firm takes some sort of action. 14.1 14.0 For the typical firm, these 5.0 5.0 are $5,145,000. 19.1 19.0 In contrast, variable 1.5 2.5 expenses tend to rise and fall automatically as sales rise and fall. As an estimation, these are assumed to be 5.0 percent of sales volume. As sales increase or decrease, they will continue to be 5.0 percent of the new sales volume. The most common response is the second column of numbers labeled Dollar Pass Through. With this approach prices to customers are increased by the same dollar amount as prices inbound have been raised by the supplier. This is probably the most common approach used by distributors. With the 5.0 percent price increase from suppliers, cost of goods sold increased from $27,475,000 to $28,848,750, an increase of $1,373,750. The result is that gross margin dollars remain constant. However, given higher sales volume (even though there is no more sales activity), variable expenses rise along with the price increase, and profit falls to $561,313. In point of fact, the dollar-for-dollar approach will always cause profit to decline. The last column of numbers is labeled Percent Pass Through but should be labeled Don't Ever Do Anything But This. It involves passing through a 5.0 percent outbound price increase because of the 5.0 percent inbound supplier price increase. In doing so, sales, cost of goods and gross margin all increase by 5.0 percent. Once again there is an automatic increase in variable expenses because of the higher sales volume. Even with this increase in variable expenses, profit rises to $918,750 and the pretax profit margin increases to 2.5 percent of sales. What this means is that when suppliers increase prices their distributors should actually thank them for their actions. The distributor has the potential to make a lot more money. On top of that, the distributor can also blame the price increase on the "idiot" supplier – the best of all possible worlds. Strategies mber In reality, the congratulations are offset by the emotional panic that sets in when raising prices sets in. If it were only one SKU increasing in price then the firm's MIS system could simply apply the same set mark-up and raise the price of the item by 5.0 percent. Unfortunately, it is usually an entire product line or an entire product segment that is affected. It is big and it is noticeable. When competition is hot and heavy, firms often retreat back to the dollar-for-dollar pass through. Strategically, the goal is to find the level of a price increase that will not cause any customer complaints. It is an admirable strategic approach, but an ill-fated profit approach. All of this leads to an important rule. When prices are rising, follow the percent-for-percent price increase formula to drive higher profit. So easy to understand, so difficult to do. Like so many other things in life. Moving Forward Pricing will probably always be the most difficult decision process for distributors. Simply put, no firm wants to be perceived as charging excessive prices. This means that when a supplier price increase materializes there will be the inevitable temptation to raise prices dollar for dollar. Whenever possible, the percent-for-percent approach needs to be substituted. A Managerial Sidebar: It is possible to estimate how much firms must raise their prices to keep profit exactly where it is in the face of a supplier price increase. The estimation process is relatively straight forward. The formula for holding profit steady, using a 2.0 percent price increase as an example, is simply: Current Cost of Goods Percentage x Size of the Supplier's Price Reduction = 78.5% x 2% = 1.6% Extreme care should be taken when employing this ratio. While it holds profit constant, the intent should always be to try to increase profit via supplier price increases. DR. ALBERT D. BATES is founder and president of Profit Planning Group. His latest book, Triple Your Profit!, is available at Amazon and Barnes & Noble. It includes Excel templates for understanding the profit structure of the firm and developing meaningful financial plans. ©2013 Profit Planning Group. AED has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited. January 2014 | Construction Equipment Distribution | www.cedmag.com | 59