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This report will attempt to provide some
guidance on the issue of what to do now. It will do so by exploring
three fundamental issues:
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Volume Sensitivity—Measuring
with precision the impact that sales has on the firm’s financial
performance.
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Sales Offsets—Identifying the
changes in expenses and margins that are required to offset a
decline in sales.
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Action Guidelines—Some specific
suggestions for ensuring the continued financial health of the firm.
Volume Sensitivity
The very first requirement is for management to fully understand its
degree of volume sensitivity. Every firm knows intuitively that if sales
fall, then profits also fall. What is not so precisely understood is the
rate at which profits fall in relationship to sales.
It is essential to understand this relationship as most firms track
sales in a real-time basis. Profitability measures, even in firms with
excellent accounting systems, often trail sales reporting by weeks or
even months. Every firm must know the impact that sales declines are
having now, while offsetting actions can be taken.
Understanding volume sensitivity is a straight-forward process. However,
it does require knowing two ratios, both of which can be estimated:
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Gross Margin Percentage—This is
simply the gross margin dollars produced as a percent of sales.
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Variable Expense Percentage—These
are the expenses, such as commissions, bad debts, overtime and
interest on short-term debt that tend to vary with sales volume
levels. This ratio is expressed as a percent of sales, even though
some variable expenses—such as commission—may be based upon gross
margin.
The result of netting these two ratios,
the volume sensitivity ratio, measures the impact of every lost sales
dollar on profits. In formula terms:
Volume Sensitivity% = Gross Margin % - Variable Expense %
A ratio of 25% would mean that every dollar of lost sales results in
twenty-five cents of lost profit. Exhibit 1 uses this ratio to measure
the impact of a ten percent decline in sales for the typical AVDA
member. As can be seen, given the size of the volume sensitivity ratio,
even such a modest decline in sales decimates profits.
At the risk of being redundant, it is
essential that this relationship be clearly understood by management. In
most instances, management can maintain grace under fire as long as the
firm is not losing money. It is only when sales have fallen
precipitously enough to eliminate profits that management begins to
consider more decisive action.
The short-run challenge is that many firms are experiencing sales levels
that put them well below break even. In such instances, firms are
actively exploring the avenues that will offset the more significant
sales declines.
Sales Offsets
Luckily, the firm’s profitability is also relatively sensitive to
changes in other factors in the business. In particular, the firm is
highly sensitive to changes in the fixed expense load and in the gross
margin percentage. These two areas must be the prime focal point of any
offset management program. Exhibit 2 examines how much of change is
required to offset a ten percent sales decline.
Expense reductions are the most natural
response to a sales decline. For most AVDA members they are also
probably the most effective in the short run. The challenges lie in
knowing how much to cut and where.
The first column of numbers in Exhibit 2 merely repeats the results of a
ten percent sales decline for the typical AVDA member. The second column
traces what the firm would have to do in terms of a fixed expense
reduction to return to its original profit level.
As Exhibit 2 indicates, the reduction required in fixed expenses is
slightly larger than the reduction in sales that drove the firm down to
break even in the first place. In every business, regardless of profit
level, it is always true that fixed expenses have to be reduced slightly
more than sales in order to maintain the existing profit level. The
problem is that fixed expenses are largely intractable. As always,
saying they have to be reduced is much more difficult than actually
reducing them.
Most managers, especially in smaller firms, would prefer not to have to
make reductions in the payroll area. The reality, however, is that
payroll and fringe benefits represent by far the largest single expense
category for virtually every firm. Some fairly spectacular expense
reductions will have to be made if payroll is going to be off limits.
The final line in the second column indicates the percentage reduction
required in non-payroll expenses alone to move the firm back to its
original profit level. As can be seen, the required reduction is well
beyond the ability of most firms. This means the firms cannot make the
reductions required without examining payroll.
Firms must make the conscious decision to either maintain profit levels
today or maintain existing staffing levels in hopes of a better
tomorrow. It is not an easy decision. What managers should not delude
themselves into thinking is that they can avoid payroll reductions and
still keep profit levels up.
The final column in Exhibit 3 looks at the change in gross margin
percentage that would be required to also move the firm back to its
current profit level. The last two items show the current gross margin
percentage and the required gross margin on the reduced sales level. For
most firms the required change is daunting, especially when there is a
downward pressure on gross margin.
Exhibit 2 does nothing to make life any easier for managers of AVDA
companies. What it does do, however, is identify the size of the
challenge they are facing. Mangers must then decide if they want to
attack expenses, gross margin or both. They also need to focus on the
areas that will improve these two factors.
Action Guidelines
It is important to understand the volume sensitivity of the firm in
order to know when to worry and how much to worry. It is also important
to understand the sales offset options to provide a sense of direction
on holding profit levels. However, it is most important to have some
ideas regarding how to make the offsets work. In that regard, there are
five critical actions for management:
Conservative Planning—Given the uncertainty of the economic
situation, firms must develop their financial plan around an extremely
conservative sales forecast. If expense needs and margin opportunities
are based on a conservative plan, the firm should be successful.
Contingency Planning—If sales fall five percent, one set of
actions are required. If they fall ten percent, then a second set is
required. Firms should plan which expenses will be cut and by how much
before sales problems develop. In this way the emotionalism of the
moment can be avoided when it is time to make the actual cuts.
Avoiding the Classic Mistakes—In an era of declining sales, one
of the first things many firms think about doing is reducing their
inventory and accounts receivable to raise cash. The results are almost
always disastrous. The inventory reduction inevitably leads to out of
stock situations and lost sales. The accounts receivable reduction also
tends to antagonize customers who are anticipating actually paying
slower. Any action that drives sales down even further must be avoided.
Emphasizing Inside Gross Margin—Suppliers are also under pressure
in a down economy. Extensive inbound margin improvement opportunities
exist. If the firm has a strong cash position, it should even consider
advance purchasing of key items. It is also a great time to ensure that
proper controls are in place to control markdowns, shrinkage and other
gross margin traps.
Getting Back to Basics—The firm needs to get everybody focused on
the customer. There is no such thing as too much service. Expense
control and gross margin management can solve some problems as shown in
Exhibit 2. Maintaining sales growth can keep the problems from arising
in the first place.
Moving Forward
There is wide-spread disagreement as to the severity and length of the
recession. If firms take the proper actions now, they will be in a
strong financial position, regardless of the economic realities. If not,
they have little choice but to try to “ride out the storm.” It may not
be a pleasant experience.
About the Author:
Dr. Albert D. Bates is founder and president of Profit Planning Group, a
distribution research firm headquartered in Boulder, Colorado. |
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