Dr. Al Bates
The Profit Planning Group
Most firms have put the bleeding of the recession behind them. While profitability is still not back to desirable levels, things are clearly improving. The operative phrase in most instances is “cautiously optimistic.”
If sales, margin and expenses follow the pattern of previous recessions, most firms will be okay by the end of the year. The typical EASA member will be far removed from the massive challenges of the past two years. On the other hand, they may be equally far removed from optimal profitability. The challenge is that in the euphoria of getting back to good, many firms will miss the opportunity to make it all the way to great.
Based upon that challenge, this report will examine two issues that are important add-ons to financial planning for 2011:
- Business as Usual—A projection of financial performance in the industry based upon a combination of past results and current trends.
- Making the Future Better—An examination of how the key factors that influence profitability can be leveraged for improved results.
Business as usual
The first column of numbers in Exhibit 1 provides a projection of overall financial results for the typical EASA member in 2011. Clearly, there is a lot of 2011 left and a lot of uncertainty still in the economy. However, it is possible to make a reasonable assumption about how the year will end up given 1) current sales trends and 2) an analysis of performance following previous recessions.
s can be seen, the typical firm is anticipated to have sales of around $3,500,000 at a gross margin of 42.0%. This should produce a pre-tax profit of $140,000, or 4.0% of sales. This is adequate, but not outstanding performance.
This means the profit results for the typical firm are expected to look a lot like they did before the recession hit. The reality, though, is that the pre-recession numbers were somewhat unexciting. Certainly, they are better than the depressed results seen during the depths of the recession. However, they do not represent the profitability that firms deserve.
It can be argued that the long-term profit results for EASA members are in something of a rut. Actual results rise and fall in tandem with economic conditions. However, across the business cycle results always revert back to the norm. That norm has been in place for an agonizingly long time.
Interestingly, profit levels have remained somewhat constant despite the fact that firms in all industries, including EASA, have become more sophisticated. For example, twenty years ago most inventory control systems were run on index cards. Today, most firms have sophisticated inventory management systems.
Increased sophistication has not lead to better results for one reason. Firms continue to make the same mistakes at the same exact points in the business cycle over and over. This is not a criticism of management. Instead, it is an inevitable aspect of human behavior.
However, improving profitability—now or at any other point in time—must involve overcoming those normal behavioral tendencies. Management must overcome the pressures that lead to business as usual.
Making the future better
The remainder of Exhibit 1 examines how the firm could produce even more profit in 2011 by better managing the Critical Profit Variables (CPVs). These are the factors that have the most power to drive profit in the firm. The three most important are sales, gross margin and expenses.
Every firm is already managing the CPVs as effectively as they can, of course. The reality is that in the recovery phase of the economic cycle, firms look at the CPVs in a very different light than they do in the down phase of the cycle. This change in perspective limits the profit potential associated with recovery.
As markets stabilize following a sharp recession two things inevitably occur. First, expenses demonstrate a relentless tendency to increase. More infrastructure is needed, employees need wage increases to “catch up” and the like. Second, pricing challenges arise. This is because the excitement inherent in sales increases automatically reduces the attention paid to pricing that is essential for desired profit performance.
It is important to note that these pressures have already been accounted for in the first column of numbers in the exhibit. That is, the exhibit assumes that human beings will continue to act as human beings. Not so much a failing as a reality of life.
The remaining columns examine the impact of maintaining greater diligence in the face of the sheer relief that the recession has ended. The two areas of focus explored in the exhibit are pricing and employee compensation. In both areas a 2.0% improvement factor is used.
The 2.0% figure is not arbitrary. The better-performing firms across a wide range of industries tend to do about 2.0% better than the typical firm each year. The 2.0% differences add up to a dramatic improvement in overall profitability.
Pricing remains the Achilles heel of every recovery. As sales rise due to improving economic conditions, there is a natural tendency to want to recover sales volume at an even faster pace. This invariably leads to a diminished level of price monitoring.
In the Margin Control column in Exhibit 1 the firm generates 2.0% more gross margin dollars. The cost of goods remains constant, so the entire 2.0% increase is the result of improved pricing. The net effect is that profit increases by 21.0%.
The Payroll Control column reflects the human tendency towards fairness. When sales growth returns, the pressures on payroll become enormous. Employees naturally want a share of the good times just as they shared in the pain of the down market. If the payroll increase can be moderated so that it is 2.0% less than might otherwise occur, profit would increase by 11.0%. Sharing is fine; controlled sharing is much better.
The real payoff, of course, comes from doing both things simultaneously. The final column of numbers demonstrates how the firm would look if both gross margin and payroll were controlled more systematically.The 32.0% improvement changes the entire profit profile of the firm.
Moving forward
After a brutal economic recession there is a tendency to dramatically under perform compared to the potential profit that could be generated. There are two serious challenges that must be overcome. First, the firm should think in terms of producing a strong profit increase rather than accepting any improvement as being good enough.
Second, the firm must be on guard for the factors that eat up the profit improvement that comes with higher sales. The firm must be especially mindful of ill-conceived expense increases and price reductions.
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