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Incremental volume is frequently expressed by the idea that if the
delivery truck is going right by a potential customer, then the cost of
making an additional stop is very low. Similarly, direct shipments are
often viewed as situations where the firm only “has to sell and carry
the accounts receivable for a little while.”
The problem with the incremental volume concept is that in the
overwhelming majority of cases the costs associated with servicing the
sale tend to be underestimated. Further, the idea of a “cost-free” sale
too often leads to serious margin erosions. The combination of
higher-than-planned expenses and a low gross margin is almost always
disastrous.
This report examines how the concept of incremental volume can be
employed successfully in distribution organizations. It does so by
examining two specific issues:
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The Economics of Incremental
Volume—A review of the impact that efforts to generate
incremental volume can have on distribution firms, under various
cost and margin scenarios.
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Controlling Incremental Sales—A
discussion of the various ways that firms can ensure that
incremental sales volume actually drives incremental profits.
The Economics of Incremental Volume
Exhibit 1 looks at the economic impact of
incremental volume, under present conditions and for three different
scenarios. The first column presents the financial position of the
typical AVDA member as reported in the PROFIT Report. As can be seen,
the firm has $150,000,000 in sales, operates on a gross margin of 21.0%
of sales and produces a bottom line profit of $5,250,000 or 3.5% of
sales.
The firm’s expenses have also been broken
down into fixed and variable expenses. The variable expenses, such as
commissions, overtime and bad debts can be expected to increase directly
with sales, even with incremental volume. These variable expenses have
been estimated as being 4.0% of sales.
Fixed expenses, in contrast, are those that could normally be expected
to remain constant as sales increase. These include a litany of factors
such as operating and administrative salaries, rent, utilities and
depreciation.
The last three columns of numbers represents the impact of a 10.0%
increase in sales under three different scenarios. In all three columns
the top half of the exhibit presents the results of the incremental
volume by itself. The bottom half represents the overall impact on the
firm with the incremental volume, margin and expenses added to the
total.
Scenario One is a pure, theoretical, incremental approach. Sales are up
by 10.0% with the same gross margin percentage as before. Of greatest
consequence, fixed expenses do not increase at all. The profit impact is
nothing short of spectacular. The only problem is that a 10.0% increase
in sales is a large jump to have absolutely no associated increase in
fixed expenses.
For very small amounts of incremental sales, the first scenario can
prove appropriate, especially in the short run. However, when there is
any significant amount of incremental volume—and 10% definitely
qualifies as significant—the fixed expenses inevitably increase.
Scenario Two combines the 10% sales increase with an 8.0% increase in
fixed expenses. The idea of sales rising faster than expenses is
commonly called expense leveraging. The 2% level of expense leveraging
in Scenario Two (10% sales increase, 8% increase in fixed expenses)
represents good performance in most distribution firms. There is still a
measurable improvement in profit, but it is much more modest.
Scenario Three represents the real problem with incremental volume—a
mutation into price cutting. In this example the incremental sales is
achieved by lowering prices on the incremental sales by 10.0%. This
means the incremental volume has a gross margin of only 12.2% rather
than 21.0%. The logic is that the fixed expenses have been covered, so
the firm can lower its prices to generate the additional volume.
However, when the price is reduced, even with expense leveraging, the
profitability of the incremental sales effort is destroyed.
Controlling Incremental Sales
Exhibit 1 reflects the two things that management must continually focus
on to ensure that incremental sales are really profitable. They are the
two things that are seldom accounted for properly.
First, expense estimates associated with incremental sales should always
be increased. This is because expenses are always under-estimated. Even
for direct shipments, there is more than simply selling and collecting.
There are always returns to handle, product functions to explain and a
myriad other costs. When costs are higher than plan, profits quickly
drain away.
Second, it should be remembered that gross margin is king in
distribution. Any program that requires a significant reduction in gross
margin should be avoided. It is always tempting to assume that if
expenses are low, then margins can be lowered and an adequate profit
generated. For most firms this is a myth.
There is another, highly strategic, problem with low gross margins on
incremental sales. As soon as one sale is made at a low margin, it is
tempting to make a second, then a third. Ultimately, there is no
stopping point on the slippery slope of gross margin reductions.
Moving Forward
If managed properly, incremental sales volume can be an important profit
driver for AVDA members. The problem is that proper management is
extremely difficult to maintain in the face of “pure, add-on” sales
volume. The larger the opportunity, the more difficult the situation is
to control.
Firms must make sure that they properly assess the true expense
relationships associated with incremental sales. Further, they must
always be aware that gross margin is the single most important driver of
profitability. When gross margin falls even a little, profit falls a
lot.
About the Author: Dr. Albert D. Bates is founder and president of
Profit Planning Group, a distribution research firm headquartered in
Boulder, Colorado.
©2006 Profit Planning Group. AVDA has
unlimited duplication rights for this manuscript. Further, members may
duplicate this report for their internal use in any way desired.
Duplication by any other organization in any manner is strictly
prohibited.
A
Managerial Sidebar on Profitable Incremental Sales Opportunities
Incremental sales can be generated in an almost infinite number of ways.
The most common ways are listed below. They are listed from most likely
to produce high profits to least likely. Ideally, this would represent
the focus of distributors in trying to enhance sales.
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Invoice Loading—The classic
strategy of trying to add an additional line to every invoice
remains the most profitable way to drive incremental sales. It
involves no more delivery stops, no more orders picked (simply more
lines) and virtually no increase in fixed expenses. It also has the
strategic advantage of taking volume from competitors.
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Product Line Extensions—Offering
additional products can produce additional sales, but there is
always an expense in purchasing, selling and supporting new
products. If the effort is geared towards current accounts, though,
the profit increase is almost always substantial.
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New Customers at Existing Margins—The
cost of finding and servicing new customers is typically higher than
estimated. From a market share perspective, though, it is the major
competitive thrust.
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Direct Shipments—Ideally, these
should be a major source of additional profits. The reality is that
such efforts are almost always under-priced as the costs associated
with handling such sales is always under-estimated. Great care needs
to be taken in this arena.
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New Customers at Lower Margins—The
lure of large volume at lower prices is almost always fatal.
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