Dr. Al Bates, President
The Profit Planning Group
The economic upheaval of the last couple of years has caused many firms to make significant changes in their operation. To a large extent, those changes caused the typical firm to end up "leaner and meaner" than it was before. It is now time to ensure that those changes also lead to improved profit performance.
The 2012 EASA Operating Performance Report (of 2011 data) suggests that at least some firms are well on their way to outstanding long-term profit performance. The key to understanding the economics of profitability is to distinguish between the performance of the typical firm and the high-profit firm. The difference is significant and appears to be widening. (The following is based on 103 participants in the EASA 2012 Operating Performance Survey.)
Typical versus high profit
The typical firm in the survey is the firm with financial performance 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. It is the best measure of industry performance on any of the profit drivers.
In 2011 the typical firm generated sales of $3,366,669. On that sales base, it produced a pre-tax profit of $151,500, which equates to a profit margin of 4.5% of sales. Stated somewhat differently, every $1.00 of sales resulted in 4.5 cents of profit. The results can best be described as adequate. Quite simply, they are not as strong as they should be.
In contrast to the typical firm, the high-profit firm generated a profit margin of 12.0%. This means that even if the high-profit firm had produced the same sales volume as the typical firm, it would have generated more profit for reinvestment in the firm. This additional asset base then would have allowed the high-profit firm to produce even more sales and profit. Over time the advantage of the high-profit firm becomes magnified. It is essential for the typical firm to implement a program to catch up quickly. Luckily, high-profit performance is open to any firm willing to take proper action. There are no barriers to success in the industry.
Driving profits to their maximum level
To reach high-profit performance the firm has to focus on what really matters. In benchmarking terms, the important items are called the critical profit variables (CPVs). While the CPVs tend to remain the same over time, their relative importance tends to vary somewhat. The CPV results for the typical firm and high-profit firm in the industry are summarized in Exhibit 1.
To a certain extent, some of the differences on the CPVs between typical and high-profit may appear to be "so what" issues. However, it is crucial to understand that very small changes in the CPVs will result in major changes in profit margin. It is a classic case of little things mean a lot. This means the typical firm doesn't have to dramatically improve performance on the CPVs, but simply do a little better across the board.
In fact, 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. This also is great news for the typical firm. Perfection is not required, only blending the CPVs in a positive way.
The CPVs that are the most important to enhancing profit results are sales growth, gross margin, payroll expenses and non-payroll expenses. Each of the factors needs to be planned carefully to ensure adequate profits.
Sales growth
The level of sales growth is always a key issue in generating adequate profits. However, there is a misunderstanding that very rapid sales growth is required for success. Nothing could be further from the truth.
The so-called ideal rate of sales growth equals the rate of inflation plus two to five percentage points. Consequently, if the inflation rate is 3.0%, then ideal sales growth would be in the 5.0% to 8.0% range. That is, there is a Goldilocks growth rate; not too slow, not too fast, but just right.
Sales growth that is too slow means that expenses, which tend to be tied closely to inflation, out-pace the rate of growth so that expenses as a percent of sales increase. Sales growth that is too rapid is also a problem. Financing rapid growth is always a challenge, and operating systems tend to get taxed when growth is rapid.
The reality is that almost no firm will ever turn down a rapid rate of sales growth. However, firms should be aware that sales solves a lot of problems, but very rapid sales growth tends to create as many as it solves.
Again, the ideal level of sales growth is to beat the rate of inflation by somewhere between two to five percentage points. Firms should make such an effort a central part of their planning process.
Gross margin
Price pressures never go away. In a down market firms are too anxious to cut prices to hold sales volume. In an up market the euphoria over increasing sales tends to reduce the diligence that should be placed on pricing.
In almost every industry an adequate gross margin is a major determinant of profitability. The real driver behind improved, or at least maintained, gross margin performance is continual monitoring. The inevitable "one-time" deals must never become the norm of operations.
Payroll expenses
Payroll is by far the most important expense factor, which means that controlling payroll is essential to controlling expenses. Payroll is another area where a specific improvement goal can be established. Ideally, payroll costs should increase by about 2.0% less than sales. For example, if sales increase by 5.0%, then payroll should only be allowed to increase by 3.0%.
This would appear to be a relatively simple, and probably easy to achieve, target. The reality is a different story. Payroll is the most difficult of all the CPVs to control. The 2.0% goal always proves difficult to achieve.
Non-payroll expenses
Most non-payroll expenses usually require only minor adjustment if sales really are rising faster than inflation. The lion’s share of non-payroll expenses is linked directly to inflation. Controlled growth should keep them in line.
Moving forward
The high-profit firms produce desired levels of performance. They also reflect the fact that there are no industry barriers to success. The key to improved performance is to develop a specific plan for each of the CPVs and combine them in a positive way. The goal is not perfection. Perfection is always the enemy of the good. The goal is to do a little better across the board.
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