The Truth About Incremental SalesCED Magazine, July 2006
Article Date: 07-01-2006
Copyright (C) 2006 Associated Equipment Distributors. All Rights Reserved.
The costs associated with servicing the sale are usually underestimated.
Incremental sales volume is the great white whale of distribution management – very few managers have actually seen it, but they have spent a lot of time and effort in the search. If they do find it, the results frequently are not what they anticipated.
Theoretically, incremental volume is additional sales that are generated without incurring an increase in expenses. In practice, incremental volume is more often an increase in sales that can be achieved with a modest increase in expenses. Incremental volume is frequently expressed as the idea that if the delivery truck is going right by a potential customer, 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 are underestimated. Further, the idea of a "cost-free" sale too often leads to serious margin erosion. The combination of higher-than-planned expenses and a lower gross margin is almost always disastrous.
The Economics of Incremental Volume
Exhibit 1 illustrates the economic impact of incremental volume under present conditions in three different scenarios. The first column presents the financial position of the typical AED dealer as reported in the 2006 Cost of Doing Business report. The firm has $30 million in sales, operates on a gross margin of 21 percent of sales and produces a bottom line profit of $750,000 or 2.5 percent of sales.
Expenses are broken down into fixed and variable. Variable expenses, such as commissions, overtime and bad debts can be expected to increase directly with sales, even with incremental volume. The variable expenses have been estimated at 4 percent of sales.
Fixed expenses, in contrast, are those that could normally be expected to remain constant as sales increase. These include operating and administrative salaries, rent, utilities and depreciation.
The last three columns illustrate the impact of a 10 percent increase in sales under three different scenarios. In all three, 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 1 is a purely theoretical incremental approach. Sales are up by 10 percent with the same gross margin percentage as before. Of greatest consequence is that fixed expenses do not increase. The profit impact is nothing short of spectacular. The only problem is that a 10 percent 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 term. However, when there is any significant amount of incremental volume – and 10 percent definitely qualifies as significant – fixed expenses inevitably increase.
Scenario 2 combines the 10 percent sales increase with an 8 percent increase in fixed expenses. The idea of sales rising faster than expenses is commonly called expense leveraging. The 2 percent level of expense leveraging in Scenario 2 (10 percent sales increase and 8 percent increase in fixed expenses) represents good performance in most distribution firms. There is still a measurable improvement in profit, but it's much more modest.
Scenario 3 is the real problem with incremental volume - price cutting. In this example, incremental sales are achieved by lowering prices on the incremental sales by 10 percent. This means incremental volume has a gross margin of only 12.2 percent rather than 21 percent. 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 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 of other costs. When costs are higher than plan, profits quickly drain away.
Second, 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, margins can be lowered and an adequate profit generated. For most firms, this is a myth.
There is another, highly strategic, problem with lower gross margins on incremental sales. As soon as one sale is made at a lower margin, it is tempting to make a second, and then a third. Ultimately, there is no stopping point on the slippery slope of gross margin reductions.
If managed properly, incremental sales volume can be an important profit driver for AED 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 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.
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