June 2015

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>> PROFIT IMPROVEMENT REPORT DR. ALBERT D. BATES T he statement "gross margin minus expenses equals profit" is an accounting tautology. It is also probably the single most important concept in improving profitability. at is because gross margin and expenses are highly correlated. Firms with high margins tend to have high expenses, while low margin firms have low expens- es. e reality is that at all points along the spectrum, from low margin/low expenses to high margin/high expenses, profits are inadequate. e key to profit improvement is to break the linkage and either produce an enhanced margin without increasing expenses or lower expenses without sacrificing gross margin. is is incred- ibly easy to talk about, but frustratingly difficult to actually accomplish. is report will examine the linkage between gross margin and expenses from two perspectives: e Nature of the Margin/Expense Linkage – An empirical examina- tion of the precise link between gross margin and expenses in distribution. Breaking the Link – A discussion of the specific margin and expense improvement levels that are required to break the linkage. The Nature of the Margin/ Expense Linkage Within every line of trade in distribu- tion, including AED, there are wide variations in the gross margin percent- age. e reasons are myriad, including different product assortments, varia- tions in the firm's service profile and strategic decisions about the role of price in the firm. At the same time, there are equally wide variations in expense percentages. ese arise because of differing levels of technology usage, the complexity of operations and, as with margin, the firm's service profile. e critical issue in profitability improvement is that the gross margin percentage and the expense percentage are essentially joined at the hip in distri- bution. is relationship is presented graphically in Exhibit 1. e exhibit highlights results from a recently published analysis of distribu- tor profitability by the Profit Planning Group. It is the largest such study ever conducted, encompassing 885 firms from 17 different lines of trade. e size of the study ensures that the results are applicable to distributors in any segment, including AED members. Across the horizontal axis the graph reflects the gross margin percentage for firms relative to other firms in the same line of trade. For example, at the 20 percent point on the axis the firm would have a gross margin percentage that is 20 percent higher than the typical firm. For AED members this would mean a gross margin of 25.2 percent of sales versus the industry norm of 21.0 percent (21.0% x 1.2 = 25.2%). At first blush, such large variations may not seem realistic. However, they appear in every sector of distribution. Joining the 40/40 Club Gross margin and expenses are the name of the game in improving profitability. 42 | www.cedmag.com | Construction Equipment Distribution | June 2015 Dramatically better is not required; slightly better is good enough. Exhibit 1 The Relationship Between Gross Margin and Expense Percentages -50 -40 -30 -20 -10 0 10 20 30 40 50 -50 -40 -30 -20 -10 0 10 20 30 40 50 Gross Margin: % Deviation from the Industry Norm Expenses: % Deviation from the Industry Norm

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