Solving the maze that chokes profits

ALBERT BATES strolled to the front of the room and asked, “How many of you want to make more profit?”

The attendees didn't exactly jump out of their shoes, but they got the message. Yes. Very much so.

In the hour that followed during his presentation, “Increase Profitability the SPEQ Plan Manual Way,” he walked them through the methods in which that can be accomplished.

Bates, founder of the Profit Planning Group in Boulder, Colorado, said the typical distributor in the truck-equipment industry — half will do better, half will do worse — has net sales of $5 million, cost of goods sold of $3.9 million, a gross margin of $1.1 million, payroll and fringe expenses of $610,000, total expenses of $975,000, a profit of $125,000 before taxes, and a 2.5% return on assets.

The problem is that, according to Bates, a company with net sales of $5 million should have a cost of goods sold of $3.825 million, a gross margin of $1.175 million, payroll and fringe expenses of $500,000, total expenses of $875,000, a profit of $300,000 before taxes, and a 6% return on assets.

He said the top industries are ceramic tile/wood flooring, security hardware, pet food, building materials, and water and sewage systems, while the bottom industries are industrial distribution.

“The industries that are most successful are specialty focused, having unique products, maybe having exclusive distribution agreements,” he said. “Industrial distribution is at the bottom because all factories have left the US and gone somewhere else, and there's nobody to sell to.”

High-profit scenario

He listed the five key characteristics of high-profit distribution industries:

  • Self-containment/barriers to entry.

    “How easy is it to get into this industry? Pretty darn easy,” he said. “What do I need besides a pickup truck? If we're going to be successful in the long term, I need to have a situation where there are a limited number of people who are doing the same thing I'm doing. Consequently, I'm not beating my brains out all on price or other competitive issues day in and day out. I'd argue this industry has very limited barriers to entry. Certainly I need capital and relationships. But I think I can get into subsets of this industry with some degree of ease.”

  • Control of the commodity component of the business.

  • Profit rather than sales orientation.

  • Internal profit understanding.

  • Restructured order economics/payroll control.

“The most profitable businesses are the liquor and beer industries. They are highly legislated businesses. If we decided we wanted to get into the liquor business today, you'd have to bribe state legislators to get in there. There are laws about who can and cannot get into the industry.

“Can we build our business where we can create the same barriers to entry in our subset, even though the entire industry may be easy to get into? It's a lot easier to run a monopoly than it is to run a business.”

He said the marketing polarity is characterized by the Gorillas (lower prices and fewer services, with a profit margin of 2.4%), the Victims (undifferentiated firms), and the Guerillas (higher prices and more services, with a profit margin of 3.8%).

“The Gorillas tend to have price as a driving mechanism for success,” he said. “They tend to be people who offer a somewhere limited service package. They tend to be large. There may not be barriers to entry, but if I'm over here, I'm in a unique market position that others may or may not have difficulty engaging in.

“Most distribution industries are smack dab in the middle, which means I spend half my day fighting a price battle and half fighting a service battle. If you're in the middle, it's very difficult to move either way. I have to do it slowly and systematically.”

He said the other big factor that tends to drive profitability is the extent to which a company is out of the commodity business.

“Every distribution business thinks that it has too many commodities,” he said, “but they are all from businesses that are totally driven. This is the second-biggest factor we found in our research: There's a very direct relationship.”

One-way street

The typical result from a pricing game is that over time, the price goes down and down.

“It's a one-way street,” he said. “It is almost impossible to make money in a commodity business. I have to get out and find something that isn't a commodity to sell. I have to get into parts and service.”

He said that a typical company (2.5% profit) has service as 8.1% of its sales and parts as 19.4%, as opposed to a high-profit company (6% profit), which has service as 17.2% of sales and parts as 25.4%.

He said that in The Challenge of the Inelegantly Named Slop-Over, low-margin pricing tends to slop over to what should be high-margin products, while high-margin service tends to slop over to what should be tonnage products.

He challenged the attendees to go back to their businesses and develop a profit plan.

“Most companies in this industry that are doing $5 million never develop a plan,” he said. “You just sell it and hope it works out. If you do develop a plan, most start with sales because it's the top line on the income statement. Then you subtract out goods and expenses, with profits being what's left over. But I don't like that.

“I'd like you to start every year with one idea in mind: How much profit are we going to make in this business? Most people get bothered by this because I'm talking about profit before we do sales or anything else. My argument is that planning profit first is the only way to improve results. The fact that we don't know sales or gross margin is immaterial. A realistic goal is a 6% ROS (return on sales) in three to five years.”

He said if pricing were raised 1%, the profit increase would be 38.4%, or $48,000.

He said the Personnel Productivity Ratio (PPR) is a crucial ratio in terms of looking at the degree to which a company is providing value profitably. The ratio is calculated by taking the percent of each gross-margin dollar that must be devoted to payroll. In the typical company, that would be $610,000 divided by $1.1 million, or 55%. He wants to see that number in the mid 40s.

“That is not an easy undertaking, but I don't think it's impossible,” he said. “If I raise the gross margin, I automatically get an improvement in the ratio without being more productive, simply by driving a higher price. If I have no growth, I can hack at this ratio.

“I can simultaneously increase my payroll (from $610,000 to $617,400) and get my people raises while also bringing PPR down (from 55.5% to 53.5%). The more sales I get, the easier the issue becomes.”

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