Dr. Al Bates, President
The Profit Planning Group
Boulder, Colorado

By almost any measure that can be used, 2009 was a tough year. However, even in the midst of a difficult econo­my, profit opportunities continued to exist. Just as in good times, some firms didn’t merely survive—they pros­pered. Understanding just how firms adapted to changing circumstances to keep generating adequate profits provides a basis for both immediate action and for future planning.

The recently completed 2010 EASA Operating Performance Report (of 2009 data) provides detailed financial and operating benchmarks for the in­dustry. As always, the primary benefit of the report is that it highlights the distinction between the performance of the typical firm and the high-profit firm. The differences are important in normal times; they are critical in tough times. (The following is based on 109 participants in the EASA 2010 Operating Performance Survey.)

Typical versus high profit
The typical firm in the survey is the firm with financial results in the exact middle of the results for all par­ticipating firms. That is, on any given measure, half of the firms performed better than the typical firm and half performed worse.

The typical firm generates sales of $3,113,440. On that sales base, it pro­duces a pre-tax profit of $87,176, which equates to a profit margin of 2.8% of sales. Stated somewhat differently, every $1.00 of sales results in 2.8 cents of profit.

In both good years and bad, most firms tend to produce results that are relatively close to those of the typical firm. The challenge when the economy slips is that being typical is only good enough for survival. They are well below the level necessary to reinvest in the firm for the future.

In contrast to the typical firm, the high-profit firm, operating with the exact same set of economic and competitive challenges, generates a profit margin of 11.4%. This means that even if the high-profit firm had the same sales volume as the typical firm, it would generate more profit for reinvestment in the firm which, in turn, will allow it to produce even more sales and profit. This is an on-going advantage which is amplified over time.  Furthermore, it is an advantage which is almost always magnified in periods of recession.

Getting profits up in a down market
Generating strong profit results is never an easy proposition. However, in a strong economy, some level of profit is almost guaranteed barring unusual circumstances. Firms can rely on sales growth to overcome poorly managed financial aspects of the business to remain profitable. With more difficult economic conditions, every aspect of the firm is under pressure and inef­ficiencies are more exposed. 

Reaching high-profit performance is a matter of identifying what factors are most important to producing profit and then developing a plan to perform better in those areas. While other factors cannot be forgotten, they are given a strong dose of benign neglect. In benchmarking terms, the important items are called the critical profit vari­ables (CPVs). The CPV results for the typical firm and high-profit firm are summarized in Exhibit 1.

Two notes of caution are always in order when comparing typical and high-profit firms. First, no firm produc­es superior results for every single CPV in either good times or bad. Successful firms manage their CPV performance so as to maximize overall profitability. Second, the CPVs that impact cash flow are not the ones that impact profit.

Cash flow
In a soft economy, one phrase that is heard often is “cash is king.” This thinking leads firms to try to reduce assets—inventory, accounts receivable and fixed assets—to convert them to cash. This cash conversion process is both understandable and, perhaps, desirable. However, it suffers from two key limitations.

First, the factors that drive cash are not the same ones that drive profitabil­ity. Cash may be an issue in a recession, but profits are an even bigger issue. The cash challenge inevitably arises because there are no profits to invest back into the firm. A serious problem arises when the “cash is king” mantra causes firms to take their eye off of the profit ball.
Second, converting assets to cash often makes the profit challenge even worse. If firms liquidate operating assets, such as inventory or accounts receivable, too much, they lessen their ability to generate sales. In doing so, they have entered a death spiral. 

For these reasons, this analysis fo­cuses on profitability. If firms are going to be successful in the longer term, they can’t just hunker down. They need to continue to build the base for the fu­ture. That base rests on higher profits.  

Profitability
In ensuring profitability in a soft market, four factors have the great­est potential impact on profit. These must be the center of planning atten­tion. These factors are sales growth, gross margin, payroll expenses and non-payroll expenses. The firms that successfully control these four critical areas have a major financial advantage in slow times which tends to carry over into good times.

• Sales Growth – The absolute level of sales volume is seldom a profit driver. Large firms may achieve economies of scale and may have advantages in pur­chasing. However, these advan­tages are frequently offset by the tendency of large firms to become bureaucratic.  
• The real issue is sales growth. In a down market growth is a scarce commodity. Even growth, however, by itself, has been overrated. The pressing need in profit improvement is to focus on sales growth relative to expense growth. Ideally, firms should target sales increases somewhere between one to two percentage points faster than the increases in operating expenses.
• In a growing market, main­taining the gap between sales growth and expense growth is not necessarily easy, but it does seem achievable. When sales are stagnant, or even declining, the degree of difficulty increases sharply. However, this sales to expense delta is always the key to profit.
• Gross Margin – The ability to generate adequate gross margin is always a major determinant of profitability. Financial success over the long term demands strong gross margin performance.  In periods of slow growth, there are intense pressures on gross margin but most firms can still find op­portunities for significant margin enhancement.
• Payroll Expenses – Payroll is by far the most important expense factor, which means that con­trolling payroll is essential to controlling expenses. In recent years payroll has rivaled gross margin in importance as a driver of profitability. This is because payroll expenses, especially the fringe benefit components, have increased relentlessly in both good times and bad over the past decade.
• Non-Payroll Expenses – Most non-payroll expenses usu­ally require only minor adjust­ment. Unfortunately, numerous expense categories must be examined and adjusted. Control­ling non-payroll expenses will probably always involve examin­ing every expense category with the goal of identifying options making modest improvements.
• Every recession eventually ends. Once it does, many firms will return to their “business as usual” routine. They would be well advised, however, to remember both the challenges and opportunities associated with this recession. A company that can build their profit base in a down market will enjoy a major advantage on the upside.

Categories: Technical topics

Tags: Profitability

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