The current attitude of most AVDA members could probably be summed up with one word—uncertainty. The economy may or may not be improving and sales may or may not grow over the next few months. In such an uncertain environment, there is a tendency to abandon the planning and controlling process. After all, why plan if you can't make any basic assumptions about the future? Instead of planning, firms often simply hope for the best.

In most instances, hoping for the best is not going to produce improved profit results. Instead, firms need to develop planning approaches that will improve results in virtually any economic environment. This process involves two components that will be the focus of this report.

• Sales Proof Planning—Using a planning approach that will improve performance under almost any future sales volume level.
• Contingency Planning—Identifying the specific actions that will be taken to support the plan under differing sales growth scenarios.

The following discussion addresses these two issues in detail. The goal is to develop a planning mechanism that will produce positive results regardless of the firm's ability to foretell the economic future.

Improved financial performance derives from either increasing the gross margin percentage or decreasing the operating expense percentage. Both areas are legitimate opportunities for improvement. However, in uncertain times there is a natural tendency to place more emphasis on expenses. The reason is that expense reductions can be achieved entirely from internal actions while gross margin enhancements require working with suppliers and/or customers.

Like firms in most industries, AVDA members have operating expenses that fall into two categories—payroll and everything else. For planning purposes more detailed breakouts are useful, but not required.

Payroll Expense is the larger of the two categories, representing total salaries and all fringe benefits. Increasingly, analysts are examining payroll costs in relationship to gross margin rather than sales. At present this number for the typical AVDA member stands at 49.0%. That is, for every $1.00 of gross margin the firm produces, 49.0 cents must go toward total payroll expense. In planning parlance this is the Personnel Productivity Ratio or PPR.

All Other Expenses includes all of the expenses other than payroll and fringe benefits. Most commonly, this ratio is analyzed as a percent of sales. For the typical AVDA member, the ratio is currently 8.7% of sales.

For both of these expense categories it is possible to set goals that should be achieved regardless of what happens to sales volume. Specifically, the following two objectives are suggested for the typical AVDA member:

• PPR—A reduction of 0.5 percentage points per year for at least three years. For the typical firm, next year the ratio would fall from 49.0% to 48.5%, then the following year to 48.0%, another 0.5 drop. Since every AVDA member is somewhat different, the guideline is not absolute. However, every firm should use it as a starting point in planning.

• Other Expense Percentage—A reduction of 0.3 percentage points per year. These expenses would then decline from their present 8.7% of sales to 8.4% next year. Again, this reduction is a good starting point for planning, but is not absolute for every firm.

Reaching these goals will have a dramatic impact on the firm, regardless of sales growth. However, the exact impact will be influenced slightly by what happens to sales. Before considering at the range of various sales results that might materialize, it is useful to look at one specific situation in detail.

In Exhibit 1 it is assumed that sales will grow by 5.0% per year over the course of the next three years. This might be a good assumption or it might be a terrible one. Ultimately, it doesn't make any difference how good the assumption is as the two goals detailed above (for PPR and other expenses) will improve profitability regardless of sales results. The 5.0% figure in Exhibit 1 simply represents one growth assumption out of many that could be made.

As can be seen in the exhibit, the two expense goals, combined with the 5.0% sales growth, produce an increase in dollar profits as well as an increase in profits as a percent of sales. The current bottom line figure of 1.7% increases to 2.9% over a three-year time period. Under this set of assumptions the profit improvement is extremely positive. The challenge, of course, is to ensure that such improved results occur regardless of sales performance. That is the challenge associated with contingency planning.

The concept of contingency planning has two components. The first component is what is sometimes called "sales ranging." This involves identifying the range of sales performance that could reasonably be predicted. The second component involves preplanning expense actions. This means determining ahead of time how specific expenses will be increased or reduced if actual sales growth is higher or lower than initially anticipated.

Sales ranging accepts the fact that the plan will not be truly beneficial to the firm unless it can produce improved performance under a variety of actual sales growth rates. The expense planning process will not cover every possible outcome, but will cover the range of likely results.

Exhibit 2 looks at the impact of the same two improvement efforts (reducing the PPR and reducing the other expense percentage) under three very different sales growth scenarios for next year: a) 5.0% growth, b) no growth and c) a 5.0% decline. With the two specific goals identified, profit will increase under all three scenarios, although not at the same rate. In addition, profit will be almost exactly the same percent of sales in all cases:

• Sales Growth—Profit increases from 1.7% of sales to 2.1% just as it did in Exhibit 1 and dollar profit increases to $3,310,650, just as before.
• No Growth—Under this assumption, the dollar profit only increases to $3,153,000. However, this is still a significant increase and was achieved in the absence of sales growth.
• Sales Decline—The beauty of planning in the mode indicated is that profits actually can be increased in a down year. While the increase is modest, it is an increase, with dollar profits reaching $2,995,350.

These three assumptions might not be the only ones that should be considered. However, taken collectively they represent the range of performance that would likely be expected.

Preplanning expense actions is at the heart of contingency planning. Exhibit 2 suggests that one specific set of expense goals can produce increased profits under a wide range of sales assumptions. However, those sales assumptions require that very different expense actions be taken in each of the different sales levels.

For example, the sales growth assumption allows payroll expense to grow from $15,000,000 to $15,589,350, an increase of 3.9%. In sharp contrast, the sales decline assumption requires payroll expense be cut to $14,104,650, a reduction of 6.0%. In the first instance, the firm is relatively relaxed about payroll expenses. In the second instance, the firm is making a significant reduction. Clearly, these are different strategies.

Preplanning expense actions involves nothing more than thinking about expense control issues before sales results are known rather than after. From a negative sales growth view, which is the one that is most difficult to deal with, it suggests knowing where cuts will have to be made well ahead of actually making them. Unfortunately, it cannot determine when during the year the firm should take the actions. It can merely identify what the actions will be.

Most AVDA members run what are still relatively small businesses. Making reductions in payroll is an excruciatingly difficult undertaking. Employees are not merely numbers as they are in gigantic corporations. They are real people with real families and real histories with the firm.

In an uncertain environment, though, it is necessary to identify which functions and which services will not be provided in the case that sales prove inadequate. Such planning is actually beneficial in and of itself as it forces the firm to think about the priorities it should have. It identifies truly essential services.

Of greater consequence, thinking about expense reductions ahead of time provides for a much for orderly perspective on the issue. Waiting until expense cuts become imperative may result in quick, off the cuff reductions. In the long run, the easy reductions may not be the right ones.

None of this makes any of the decisions any easier. However, if contingency planning is used properly, with realistic goals such as the ones identified here, the process should allow firms to produce the profits they require.

If AVDA members can focus their planning on expense control in relationship to sales rather than merely on sales itself, they can develop plans that will improve results regardless of sales growth rates. However, ensuring that higher profits are generated requires the firm to think seriously about the specific actions that will be taken under a range of different sales realities. Firms that can make that commitment can guarantee profits regardless of the economic uncertainty.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2002 Profit Planning Group. AVDA has unlimited duplication rights for this manuscript. Further, AVDA members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.