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The Investment Versus Sales
Trade-off—An examination of how investment reduction programs have
the potential to either increase or decrease profitability.
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Having Cake and Eating It Too—A review
of the opportunities for investment reduction that can be undertaken
without risking sales decline.
The Investment Versus Sales Trade-off
To understand how investment and sales reductions work their way through
the business it is necessary to have a precise understanding of the
financial structure of firms in the industry. Exhibit 1 provides
financial results for the typical AVDA member. Typical means that half
of the firms perform above the results shown in Exhibit 1 and half
perform below the results.
According to the most recent PROFIT Report, this typical firm generates
$100,000,000 in sales volume, operates on a gross margin of 21.5% of
sales and produces a pre-tax profit of $2,000,000 or 2.0% of sales. The
firm is also assumed to have variable expenses (commission and the like)
of 4.0% of sales.
The key investment issue is that the firm requires $28,500,000 in total
assets in order to generate this level of sales and profit. Of this
amount, $11,200,000 is in inventory and $12,750,000 is in accounts
receivable. These results are shown in the first column of the exhibit.
The second and third columns examine the impact of an investment
reduction, but do so under very different circumstances. The second
column assumes that both inventory and accounts receivable can be
reduced without impacting sales volume. The final column looks at the
consequences of an investment reduction that results in a modest sales
decline.
In both of the “what if” columns the investment in inventory and
accounts receivable has been reduced by 10%. It is also assumed that the
cost of carrying inventory and accounts receivable is around 20%. That
is, for every dollar of investment reduction, profits would increase by
20 cents due to less interest, a reduction in insurance on inventory,
fewer bad debts and the like.
A 20% factor for inventory is about what most inventory consultants
suggest should be used for inventory. For accounts receivable, a 20%
factor overstates the carrying costs by a large extent since the only
carrying cost items are interest and bad debts. Consequently, the cost
reduction factors in the exhibit are slightly over-stating the profit
impact of an investment reduction.
As can be seen, if there is no sales decline, the cost reduction (line
item “Reduction in Carrying Costs” in the exhibit) is significant. Costs
decline and profits increase by $479,000. At the same time, the
reduction in investment is also significant. When the investment
reduction and the profit improvement are combined, ROA increases
sharply, from 7.0% to 9.5%.
The problem in distribution is that investment reductions are almost
always associated with reductions in sales activity. This is due to
out-of-stock conditions on inventory and the reluctance to provide
credit to marginal customers on accounts receivable.
In the final column of the exhibit, it is assumed that sales decline by
5.0%. This is not meant to imply that a 10.0% investment reduction will
automatically result in a 5.0% sales decline. It is merely a pro forma
set of results. The actual sales decline may be more or less than 5.0%.
In any event, the sales decline destroys the financial structure of the
firm. With a sales decline, it is impossible to shed fixed expenses. The
result is that profit declines from $2,000,000 to $1,604,000. Even
though the asset investment is reduced, ROA actually falls from 7.0% to
6.1%. Simply put, sales is much more important than investment levels in
determining the financial success of the firm for AVDA members.
This profit impact of “sales not made” is not well understood as
traditional information systems simply can’t provide pro forma income
statements that add back sales that were lost. Since the profit impact
of investment reductions are highly visible and those of lost sales are
not, there is a natural tendency to move toward an investment reduction
approach.
Having Cake and Eating it Too
Few distributors have as much cash as they desire. The instinctive
reaction is to lower investment levels. However, such actions are likely
to lower profits which makes the investment challenge that much harder.
There are two solutions to this challenge—drive profits higher or
eliminate marginal investments.
Driving Profits Higher—For most firms it is absolutely essential to
place more emphasis on increasing profits and less on lowering
investment levels. This means avoiding investment myopia which results
in blanket reductions in either inventory or accounts receivable.
If the firm can generate an adequate level of sales volume and a
realistic gross margin on those sales, profits tend to increase almost
exponentially. The key to this strategy is to have the right product in
stock when customers want it and to be willing to finance those
purchases. There is no other realistic approach to profit improvement.
Eliminating Marginal Investments—The key to investment reduction success
is focusing on where the investment is doing little to help the firm
generate sales and profits. In inventory planning this is easy; for
accounts receivable planning it is much more difficult.
In inventory the problem investments are easy to identify. They are
items that have not sold during the last year. Monitoring systems must
be in place to highlight these problems and management must deal with
them on an on-going basis. Dead inventory never returns to life.
For accounts receivable the issue is more complex as it is not just the
slow-paying accounts, but those which are slow paying and also generate
low levels of sales and gross margin. This requires a system to evaluate
the overall profitability of accounts and commensurate ability to make
pricing adjustments where the return does not justify the investment.
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 Measuring the Trade-off Between Investment
and Sales
It is possible to measure the size of the sales decline that will offset
the profit impact of an investment reduction. Doing so requires a
variation of the standard break-even formula. The calculations below
demonstrate how the current profit level would be maintained for the
typical AVDA firm. As can be seen, for the typical member, a sales
decline of 2.7% will exactly offset a 10.0% reduction in inventory and
accounts receivable.
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