Profit Improvement: Remembering the Mistakes of the Past - Financial Management
Construction Equipment Distribution magazine is published by the Associated Equipment Distributors, a nonprofit trade association founded in 1919, whose membership is primarily comprised of the leading equipment dealerships and rental companies in the U.S. and Canada. AED membership also includes equipment manufacturers and industry-service firms. CED magazine has been published continuously since 1920. Associated Equipment Distributors
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Profit Improvement: Remembering the Mistakes of the Past

Written By Dr. Albert D. Bates

Article Date: 10-01-2005
Copyright (C) 2005 Associated Equipment Distributors. All Rights Reserved.


In every recovery, too many dealers make the same mistakes.

Distributors are about to test the accuracy of George Santayana’s famous quotation: “Those who cannot remember the past are condemned to repeat it.” More likely than not, the results of the test will not be pretty. The economy has just emerged from a rather ugly recession, just as the economy emerged from recessions numerous times in the past. Time after time, distributors have made the same mistakes during the recovery.

With planning, those mistakes really should be avoidable this time.

The Traditional Mistakes

In every recovery, far too many distribution executives make the same mistakes. They don’t make them because of a lack of experience; many managers have already experienced these challenges once or twice. They make them because the pressures that recur automatically at the beginning of every recovery period are almost impossible to resist. Those mistakes are uncontrolled growth, payroll expense pressures, and excessive inventory investment.

  • Uncontrolled Growth Suggesting to any manager at the end of a recession that there can be too much growth is a sure way to be heaped with ridicule.

    The worse the recession, the more surely the recovery is greeted with the sales manager’s adage that sales growth solves all problems. Actually, sales growth both solves and creates problems.

    The major problems associated with excessive sales growth are operational in nature. Sharp sales increases place a severe strain on the staff. Out-of-stock situations arise, errors in the warehouse and shipping multiply, and customer complaints begin to be heard.

    No firm is going to say no to additional sales. However, every firm should follow three simple guidelines with regard to sales growth.

    First, give primary sales support to those customers who were loyal during the recession. Second, hold the line on margins. Far too much of the “incremental sales growth” during the recovery is lower margin activity that may or may not help profits. Third, track key operating ratios, such as lead time on outbound orders and service level, very closely. Even modest reductions in performance are often the precursors of poor profit results.

  • Payroll Expenses Interestingly, the payroll problem does not occur during the first year of recovery, it develops during the second year. The problem is directly associated with Fred.

    Fred is a loyal and hard-working employee who has been with the firm many years. Fred has a family. Fred has not had a significant pay increase in a couple of years because of the recession. It is time to help Fred catch up. When that occurs, Fred will win and company profits will lose.

    Payroll must be matched against sales and margin, in good times and in bad.

  • Inventory Investment During the downturn, cash flow pressures typically cause distributors to lower inventory. When sales start back up, out-of-stock situations frequently arise. The inevitable result is a rush to replenish inventory. Too often inventory grows in an uncontrolled manner.

    The frequent result is a severe cash flow strain. At the very time the firm is beginning to produce higher sales and stronger profits, cash balances begin to fall precipitously. Inventory investments need to be focused in product areas where they produce additional sales.

 A Planning Perspective

The enthusiasm of the recovery needs to be tempered with a commitment to planning. This applies to the entire business. However, the challenges can be seen most directly in payroll.

As was mentioned earlier, payroll pressures tend to appear in the second year of a recovery. The first year is usually one of making certain sales really have turned up. During that phase, management remains diligent in controlling expenses.

In the second year, the philosophy changes somewhat. Pay increases become easier to justify and efforts to rebuild the employee infrastructure take place. This typically happens just as the large increases in sales are giving way to more modest ones.

As shown in the chart on the previous page, for the typical AED dealer -, who has sales of $26,500,000 - payroll represents 57.9 percent of total expenses. As payroll goes, so goes the firm. If that dealer enjoys a 5 percent sales growth and payroll expenses increase by 4 percent, the increase in sales causes profits to rise from $424,000 to $476,205.

If payroll grows with sales at 5 percent, profit increases by the same 5 percent to $445,200. However, if payroll expense growth is out of control - a 6 percent increase - profits decrease to $414,195. The firm is in the unenviable position of selling more and making less.

On the surface, the difference between a 4 percent and a 6 percent increase appears to be extremely small. However, the profit impact is huge, with a profit of either $476,205 or $414,195 on the same sales volume. The exhibit suggests that even modest miscalculations on sales growth vs. expense growth have large implications for the dealer.

The watchword for the second year of recovery must be conservatism. It is essential to control payroll in relationship to actual sales growth, not desired growth.

Moving Forward

The recovery should be a time of major profit growth for AED member dealers. Indeed, results reported in the 2005 AED Cost of Doing Business Report indicate sharp improvements.

Whether those improvements continue depends upon the extent to which firms avoid the inevitable pressures that accompany recovery.

Of all the pressures the firm faces, payroll expense growth is by far the most important. It must be the central concern of every manager.

 


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