Only Spend What You Earn - On The Numbers
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SECTION: On The Numbers

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Only Spend What You Earn

Written By: Gary Bartecki

Article Date: 02-01-2005
Copyright(C) 2008 Associated Equipment Distributors. All Rights Reserved.

Profit is the name of the game.

We all go through some sort of budget and cashflow budgeting process, or at least I hope we all do, and sometimes it works out and sometimes it doesn't. The times we really get upset are when we hit the sales bogie but don't make budget. One of the reasons budgets don't always work as planned is directly tied to the profit planning model we use. Most people prepare their budgets by first estimating sales figures and then working down from there. They look at prior years, consider changes they've made, review both the dollars and percentage to sales, and write in a figure for the upcoming period. Pretty standard approach.

To insure profitability, however, you have to take the process two-steps further:

  • Make absolutely sure your gross profit figures are as accurate as they can be
  • Calculate expenses in relationship to the gross profit dollars available
Adding these two steps provides more-accurate planning tools because the results tell you what you can spend for selling, general and administration expenses, e.g. the gross profit dollars you generate, not the sales dollars you generate.

Many dealer metrics follow this principle. They measure departmental personnel costs against departmental gross profits. Want to hit the required contribution margin? Avoid overspending on departmental personnel costs. Hit the benchmark percentage of personnel cost against departmental gross profit, and you will likely hit the goal. The same goes for other departmental direct expenses.

If you follow this approach and measure expenses against gross profits for each department, and also for admin salaries, occupancy costs and admin costs, you're 90 percent of the way to hitting the "high profit" operating results for your industry.

For example, assume a company with a 28 percent gross profit margin spends 15 percent of sales on personnel costs (other than costs included in cost of sales). Convert that to a percentage of gross profit, and you get 55 percent of gross profit being spent on payroll.

If sales stay the same and gross profit decreases 1 percent, you have to reduce personnel costs to stay even. Personnel costs as a percentage of sales would remain the same under both scenarios, but cost you dearly in example #2 because you have fewer dollars to spend on payroll.

With this simple example, you can see that using sales as a benchmark can make you miss required budget changes to maintain profit goals. Using gross profit as the benchmark provides a better understanding of what you need to do to hit profit goals. In this case, not making that adjustment to maintain personnel costs at 54 percent of gross profit dollars available would cost this company more than $100,000.

You can use this tool effectively by comparing your results with other companies in the same business. To do so, however, requires definitive rules and guidelines on how to calculate gross margins.

Using gross profits as a benchmark tool provides more control over profits. And profit is the name of the game.

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Article Categories:  Financial  »  Taxes