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April 2014 | Construction Equipment Distribution | www.cedmag.com | 35 Profit Improvement Report In short, sales growth is nice. However, the factors underlying the sales growth are decidedly more important than the sales growth itself. The deterioration in gross margin and payroll expense perfor- mance must be reversed. If that can be achieved, the typical AED distributor is positioned for strong profit results. Changing the Sales-to-Profit Relationship The profit challenges facing distributors today are nothing more than a repetition of the chal- lenges that have followed every period of economic sluggishness and recovery. The euphoria of sales growth causes managers to forget most of the painful lessons learned in the down period. As demonstrated in Exhibit 1, those lessons are centered on gross margin and payroll expense. While both of these factors are important, gross margin is the real profit driver. Gross Margin – The total profit swing between the Profit Enhance- ment and Profit Deterioration scenar- ios in the exhibit is $325,000. Of that amount, $215,000, or 66.2 percent comes from gross margin. Experience from prior periods of strong sales growth suggests that the gross margin issue is nothing more than one of focus. The sad reality is that gross margin walks out the door when strong sales growth walks in. Getting the margin focus back requires communication, analysis and emphasis on some mundane opera- tional issues. The communication issue requires reinforcing the important of price integrity throughout the firm, but especially to the sales team. Without constant reminders regarding pricing, gross margin slippage occurs almost automatically. The analysis component involves finding hidden opportunities to improve gross margin. In both good times and bad, firms continue to underprice their slowest selling items and special-order merchandise. The improvement potential is more substantial than most firms believe. Finally, it is also essential to deal with the pesky operational issues that are ignored when everybody is busy with growing sales volume. Pricing errors are endemic to firms with lots of SKUs. Cleaning them up creates "free" gross margin dollars. Tighter control of shrinkage also represents a significant opportunity. Neither of these topics is exciting, but both are important. Payroll Control – The keys to payroll control are twofold. The first is euphoria. The second is an infrastruc- ture bias. The euphoria problem arises because there is an understandable tendency to want to help employees "catch up" on payroll increases that may have been deferred during the down economy. In thinking about such catch-up situations, though, it is essential to ensure the increase in payroll follows rather than leads the increase in sales volume. The infrastructure bias comes into play because now that sales are up nicely, the firm would like to gener- ate even more growth. The thought process is that if the firm increased its infrastructure (sometimes more correctly called adding overhead), then sales growth would be not just nice, but even more spectacular. The timing of such increases, in terms of additional sales staff, must be related directly to real sales poten- tial, not to some vague desire for even more growth. Moving Forward Distributors in every line of trade are facing the challenge that sales growth is simply not translating into profit growth. It is a pattern that repeats itself every time a sluggish economy gives way to sales growth. The key for distributors, including AED members, is to maintain control over gross margin and payroll expenses. If that is done properly, strong profits will follow strong sales growth. n Current Business Profit Profit Income Statement ($) Results As Usual Deterioration Enhancement Net Sales $50,000,000 $55,000,000 $55,000,000 $55,000,000 Cost of Goods Sold 39,250,000 43,175,000 43,282,500 43,067,500 Gross Margin 10,750,000 11,825,000 11,717,500 11,932,500 Expenses Payroll and Fringe Benefits 5,500,000 6,050,000 6,105,000 5,995,000 All Other Expenses 3,500,000 3,850,000 3,850,000 3,850,000 Total Expenses 9,000,000 9,900,000 9,955,000 9,845,000 Profit Before Taxes $1,750,000 $1,925,000 $1,762,500 $2,087,500 Income Statement (%) Net Sales 100.0 100.0 100.0 100.0 Cost of Goods Sold 78.5 78.5 78.7 78.3 Gross Margin 21.5 21.5 21.4 21.7 Expenses Payroll and Fringe Benefits 11.0 11.0 11.1 10.9 All Other Expenses 7.0 7.0 7.0 7.0 Total Expenses 18.0 18.0 18.1 17.9 Profit Before Taxes 3.5 3.5 3.2 3.8 Exhibit 1: The Impact of 10.0% Sales Growth for the Typical AED Member ------------------10.0% Sales Increase------------------ Dr. AlberT D. bATes is founder and president of Profit Planning Group. His latest book, Triple Your Profit!, is available at: www.tripleyourprofit- book.com, as well as Amazon and Barnes & Noble. It includes Excel templates for understanding the economics of the firm and planning future performance. ©2014 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. 34_Bates_Profit_Feature_KP.indd 35 3/27/14 4:33 PM