They're Back! Your Main 'Muscle' for Profitability Never Really Go Away - Profit
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They're Back! Your Main 'Muscle' for Profitability Never Really Go Away

By Dr. Albert D. Bates

Article Date: 12-01-2010
Copyright(C) 2010 Associated Equipment Distributors. All Rights Reserved.

Unfortunately, gross margin and payroll are also the most challenging to manage.

Editor's Note:
Hear Al Bates live at the AED Summit in Orlando - he conducts an executive seminar, "The Distributor's Action Plan for Achieving Profitability," on Thursday, Jan. 27, beginning at 3 p.m. (Register at His firm produced AED's 2010 Cost of Doing Business Report, and he may, indeed, possess more distributor profitability data than anyone else in North America. KP

Every few years this report series returns to the two big issues in improving profitability - gross margin and payroll. This redundancy is required because these two factors continually prove to be the ones that are the most difficult to bring in to line and the easiest to fall out of line.

The pressures associated with a somnambulant economy give these two factors even more relevance. When things are slow, price pressures are inevitable. At the same time, sluggish or declining sales volume almost always results in an increase in payroll expense as a percent of sales.

This report will examine two different issues associated with getting control of both gross margin and payroll:
  • Measuring Performance - A review of how to best measure gross margin and payroll performance in a changing environment
  • Setting Gross Margin and Payroll Goals - The development of specific targets for improvement to return performance to desired levels
Measuring Performance
When things are in a state of flux, such as during a recession, individual performance measures often become temporarily distorted. Gross margin as a percent of sales might fall to extremely low levels. Further, it is usually not possible to reduce payroll as fast as sales fall, so payroll percentages rise sharply.

While no ratio is perfect under such conditions, probably the one that's most beneficial for measuring margin and payroll control in aggregate is the Personnel Productivity Ratio (PPR). The PPR is payroll (including all fringe benefits) expressed as a percentage of gross margin dollars.

Exhibit 1 provides a financial overview of a typical AED member firm based upon the CODB Report. The first column in the exhibit provides current results in both dollars and as a percent of sales. The PPR calculation is also provided.

Exhibit 1

This firm generates $30,000,000 in revenue and earns a pre-tax profit of $60,000, or 0.2 percent of sales. The keys to generating this level of results are a gross margin of 22.0 percent of sales and payroll expense of 12.5 percent of sales.

These figures result in a PPR of 56.8 percent (payroll expenses of $3,750,000 as a percent of gross margin of $6,600,000). This means that for every $1 of gross margin that is generated, 56.8¢ must go to payroll. This leaves 43.2¢ to cover all other expenses and generate a profit.

Almost all of the PPR guidelines bandied about are pure mythology. It is impossible to set an absolute goal without understanding the economics of the specific line of trade. The best way to set a goal is to examine the performance of the high-profit firm as reported in the AED CODB Report.

Based upon this data set, a realistic PPR goal is approximately 46.5 percent. This means that the typical firm should be looking for a reduction in the range of 10.3 percentage points over time. The challenging issues, of course are (1.) how quickly can results be improved, and (2.) how to make the improvement.

Setting Goals for Gross Margin and Payroll
Managerial SidebarUnfortunately, reducing the PPR by 10.3 percentage points is not an actionable objective. It is too difficult to understand exactly how improvements can be made. It is necessary to break the PPR into its two components - gross margin and payroll expense - and set individual goals for each of them.

Setting goals for these items is a company-specific undertaking. However, every firm should set goals that can be viewed as "bitesized chunks" that can be readily achieved. A realistic starting point is to improve these factors by about 1 percent. Exhibit 1 reflects such a small but meaningful undertaking. For ease of understanding, the table demonstrates the impact absent any sales increase for the firm. All the changes are related to gross margin and payroll.

Specifically, in the second column the firm generates 1 percent more margin dollars on the same sales. In the third column the firm reduces its overall payroll burden by 1 percent, again with the same sales. The final column demonstrates the impact of making both changes at the same time.

Both actions cause the PPR to fall to 56.3 percent. However, since gross margin is a larger number than payroll, the improvement in margin has a larger impact on net profit before taxes than the improvement in payroll. Both are key drivers of performance, though.

Ideally, the firm can make both margin and payroll improvements at the same time. In the last column, the PPR falls to 55.7 percent. This is twice the impact of each of the changes being made separately.

The entire intent of the exercise is to set some goals that everybody in the firm feels can be met, even in a period of economic challenges. The reality, though, is that goals are simply abstract ideas until a specific action plan for their achievement is put in place.

Gross Margin - In the current economic environment, substantial price increases are a pipe dream. However, firms continue to under-price their slowest selling items and special-order merchandise. The improvement potential is more substantial than most firms believe. Slow economic times also create an opportunity to deal with problems that are ignored when everybody is too busy. Pricing errors are endemic to firms with lots of SKUs. Cleaning them up creates "free" gross margin dollars. Tighter control of shrinkage also represents a significant opportunity.

Payroll Expense - Most firms continue to believe that productivity improvements (better scheduling, automated warehousing, etc.) will solve the payroll challenge. Historically, productivity improvements have driven higher levels of sales per employee, but have done nothing to lower payroll costs as a percent of sales or lower the PPR. Wages, health care premiums and the cost of other benefits have risen right along with sales per employee.

The key to payroll control is two-fold. First, more attention must be given to order economics. The number of lines per order and the average line value must be increased. This is not really a productivity improvement - this actually results in doing less work. Second, the service profile of the firm needs to be examined. Most firms provide a lot of wonderful services and a few that nobody cares about. It is time to drop services that don't enhance profitability.

Moving Forward
The never-ending economic challenges being experienced at present have taken as much of a toll, psychologically, on employees as they have on profits. When the staff is tired and the future uncertain, improvement plans lose credibility.

This is a great time to set small improvement targets combined with strong implementation plans. The 1 percent goals identified here are one such opportunity. Over time, small improvements in the key drivers of profitability will generate significant improvements in the bottom line.

Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colo. © 2009 Profit Planning Group. AED 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.
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