|
Analyzing Profit Opportunities—A financial review of how
different management actions impact profitability.
Opportunity Versus Perception—A
discussion of the inherent difficulties in keeping employees focused on
the greatest areas of opportunity.
Analyzing Profit Opportunities
The very first requirement in setting profit priorities is in
understanding how much effort will produce how much reward—in management
parlance the proverbial bang for the buck. Exhibit 1 presents some bang
for the buck analysis for a typical AVDA member.
Candidly, Exhibit 1 was first developed in the Pleistocene Age. There is
probably no senior manager who has not seen Exhibit 1 at least fifty
times. However, far too many managers take actions that suggest they are
oblivious to Exhibit 1. Consequently, it will be reviewed here for the
fifty-first time.
The exhibit measures the percentage change
in dollar profit that will be generated by improving performance by one
percent in six different areas. For example, the very top line indicates
that if the typical AVDA member increased its prices by 1.0%, then
dollar profit for the firm would increase by a rather staggering 48.0%.
The biggest bang for the buck is in increasing prices, followed fairly
closely by lowering merchandise costs through better buying. There is
then a perceptible gap before these results and those from increasing
sales or reducing expenses. Interestingly, the impact from sales growth
and expense control are almost identical. Finally, there is another
significant gap before reaching the impact of reductions in either
inventory or accounts receivable.
In a perfect financial world, the management team would array its
operating priorities to reflect the realities of Exhibit 1. In point of
fact, the priorities in most firms deviate widely from what is shown in
Exhibit 1, to the detriment of profit performance. Ideally, priorities
should be brought back into line with Exhibit 1. In reality, much easier
said than done.
Opportunity Versus Perception
In practice, firms ignore the implications of Exhibit 1 for at least
three reasons. First, many firms are cash constrained which causes them
to abandon profit priorities in favor of cash priorities. Second, some
items on Exhibit 1 may be perceived as harder to achieve than they
really are. There is a natural tendency to migrate where the effort
required is less. Finally, some of the items shown on Exhibit 1 have a
much stronger motivational pull than others.
Cash Management—Most AVDA members are somewhat cash constrained.
Generating cash is always an issue. As a result, managers continue to
place a lot more attention and effort on reducing inventory and accounts
receivable than the exhibit suggests they should.
Such a cash focus is understandable; but is also very wrong. Inventory
and accounts receivable reduction programs ameliorate the cash flow
problem only in the short run. The only viable solution for solving the
long-term cash flow issue is to generate substantially higher levels of
profit. Exhibit 1 is not only the path to higher profit, it is the path
to more cash.
Degree of Difficulty—Certainly it is easier to make changes in
some areas than it is in others. In some firms it may be much easier to
reduce inventory than it is to increase prices. The size of the
challenge must be considered in planning.
What distribution managers must not do, though, is confuse the
difficulty of doing something with its profit impact. That is, they
should not decide that just because something is difficult to do it
should be avoided. This is especially important in examining the
trade-off between different variables.
For example, if gross margin is difficult to improve and inventory is
relatively easy to improve (nothing being easy), that should not be an
excuse to avoid attacking gross margin. It is essential to understand
why this is so.
Taking the typical AVDA member in Exhibit 1, a 1.0% price increase
causes dollar profits to increase by 48.0%. At the same time, a 1.0%
reduction in inventory increases profits by only 0.8%. These two can be
related from a degree of difficulty perspective.
To reach the same level of profit improvement as a 1.0% price increase
would requires lowering inventory by 57.4% (48.0% divided by 0.8%). Is
it easier for the firm to lower inventory by 57.4% or increase prices by
1.0%? The answer may still be inventory. It would be very nice if the
answer to focus on inventory were made on the basis of the right
information.
Motivational Impact—The numbers in Exhibit 1 provide a sense of
direction for the firm in terms of where to work. However, they have no
value in motivating employees to make changes. This is because some of
the things with a small payoff might be much more fun to do than some
things with a large payoff.
As an obvious example, most managers relish opportunities to increase
sales. It is a dynamic process. In contrast, expense control often has
the same motivational component as cleaning the leaves out of the
gutters. It probably ought to be done, but it sure isn’t much fun.
Even increasing prices, which is king of the hill in Exhibit 1, may have
a negative connotation. If there is a deep-seated belief within the firm
that prices are too high, then prices really are too high. Perception,
even when utterly wrong, is reality. To urge the firm to move forward
without a proper belief in what is being done is folly. The motivational
component associated with the various activities in Exhibit 1 must be
central to management’s thinking.
Moving Forward
If AVDA members are going to generate higher levels of profit, they must
pay homage to Exhibit 1. However, it is not enough to simply make sure
that every member of the management team understands Exhibit 1. Every
member must set priorities that actively support Exhibit 1.
Making Exhibit 1 an integral part of management action requires a strong
motivational effort. That effort needs to be on-going rather than
episodic. It is a lot of work. The payoff, though, is a lot of profit.
About the Author
Dr. Albert D. Bates is founder and
president of Profit Planning Group, a distribution research firm
headquartered in Boulder, Colorado.
©2007 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:
Analyzing One Percent Changes
For readers who have not seen Exhibit 1 before, the analysis is far from
self-evident. The following illustration outlines how the profit
increase figures for both a sales volume increase and a price increase
were calculated. The other items in Exhibit 1 were calculated in a
similar fashion.
The only item that might not be straightforward in the analysis is that
variable expenses were assumed to be 4.0% of sales. This covers
commissions, overtime, bad debts, bank card charges and the like.
|
|
