AL Bates, chairman/president of the Profit Planning Group, believes most distributors in the heavy-duty industry are capable of making more money.

And not just a little bit more. How about three times more?

“That’s a heck of a change,” he said. “That’s a gigantic change. Maybe you’ll say, ‘Oh, my I can’t do three times as good.’ But if we can make some small changes, we can drive three times the profit.”

Bates is so confident that he wrote a book, Triple Your Profit! Stop Being a Profit Soldier and Start Being a Profit Winner.

In his presentation, “Managing the Key Profit Indicators (KPIs),” he presented the financial results for
Mountain View Inc, a fictional $20 million company but one he says is a typical heavy-duty distributor, with half of the companies doing better and half doing worse.

It has a gross margin of 32%, which he says is too low.

“That means we provide a lot of services of great value but we’re not getting paid for it what we should, so we need improvement in gross margin.”

He said the company’s payroll and fringes are twice as big as anything else—$4 million—which is too high.

The profit is $500,000, or 2.5%. The total assets are $7.5 million, meaning the company had to invest $7.5 million this year to provide $500,000 of profit, including $4 million in inventory and $1.75 million in accounts receivable.

He said the cash figure of $225,000 is not enough.

“Every distributor in the world complains they don’t have enough cash,” he said. “Microsoft has cash. Banks have cash. Acne-faced kids who have just launched web sites have cash.  And as a distributor, I don’t.”

He said the #1 metric to look at is the key profit indicator, or profit pre-tax.

Return on assets equals profit before taxes ($500,000), divided by total assets ($7.5 million), or 6.7%.

“If this were a risk-free business, I could live with that,” he said. “It is not risk-free. It is a different business, and 6.7% isn’t enough. I’d like to have a 20% return.”

There are two strategies for getting better ROA:

  • Increase PBT profit before taxes. “That is the one you should be focusing on.”
     
  • Decrease asset investment. “It’s been popular over the last seven or eight years. Lower asset investment, lower inventory and accounts receivable. If we can we run this business with less money tied up, that’s possible. But in all candor, I don’t think there is a big takeout.”

He said an investment reduction involves reducing inventory and accounts receivable, but that doesn’t have a dramatic effect.

“If I reduce inventory or accounts receivable, I can reduce it until I’m blue in the face, and ROA barely goes up,” he said. “If I’m going to reduce inventory, two things should be happening at the same time: assets going down and profit going up. The problem is, over the course of the last 10 years, people in distribution have been focusing on how to get inventory and accounts receivable down. Congratulations, you just wasted 10 years of your life. It is not a KPI. It’s not one of the drivers of profitability.”

A sales increase produces a sharp increase in ROA, he said, but decreasing expenses is even more effective.

“The big problem is that expense control has lousy public relations,” he said. “Expense control is viewed as better than the Ebola virus but not as good as the post office. Expense control means you’re going backwards. Sales volume means going forward. Expense control means we are spending too much on expenses, particularly in regards to payroll.”

Rack-Suit Plan

Bates said KPIs need to be prioritized in a meaningful way. He said executives typically hear his presentations and go back to their companies, but get immersed in the minutiae of the day. To simplify it, he recommends thinking that gross margin is the #1 concern, followed by expense control, sales, and inventory and accounts receivable.

To determine how much of each, he said a good starting plan is his “2/2/2 Model: A Rack-Suit Plan.”

There are four parts to it:

•  Increasing sales by at least the inflation rate (2%), plus the safety factor (3%), or 5%. “I need sales to go north. You cannot have them going south. For those of you old enough to remember those wonderful years in the late 1970s, the inflation rate was 18%. Eighteen plus three is 21. I don’t want to go back there.”

  • Forcing payroll to increase by 2% less than sales. “This is for everybody. This is not a rack suit. It’s a tailored suit. However fast your sales increases in your business, I want payroll to go up 2% slower. If sales are up 5%, payroll can only go up by 3%. This is something every firm needs to do.”
     
  • Increasing the gross margin percentage by 0.2%. “It’s not the gross margin dollars. It’s gross margin percentage. That’s 32% for this company. We want to take it to 32.2%. I’m going to do it by pricing and buying and a lot of things involved in that process. This is not easy, but it’s achievable attainable, doable—all sorts of buzzwords for ‘hard.’ ”
     
  • Decreasing the other expense percentage by 0.2%. “This is quasi-automatic. We have non-payroll expenses: rent, utilities, depreciation, interest. Those were 9.5% of sales. I want to take them to 9.3%.”

“Most people in this industry by definition are reasonably close to typical,” he said. “This is a starting point. The bad news is, you can’t just do it once. I want you to do it five years in a row. All of them are achievable, attainable, realistic, and doable. They are not easy to do, but they are crucial. These things—which by themselves are not that big—will drive three times the profit.”

Part of his plan deals with “controlling payroll without sacrificing employee enthusiasm,” which he couches by saying, “Well, maybe a little.”

“I don’t want them real mad,” he said, “but I want them to be not as mad. I don’t want them to be upset.”

The idea is to build a 2% sales-growth-to-payroll-growth gap.

“That means sales goes up 2% faster than payroll,” he said. “You say, ‘We’re actually having a good year.’ Sales are up by 10%, but now we need more infrastructure, we need a new driver, and a counter person. My expenses are up by 8%, and 10 minus 8 is 2. If sales are up by 15, I need a lot more people.

“Here’s where I have a different perspective: I think all of these are equally good. What I will not let you do is let you say, ‘I’m going to have sales go up 15% and payroll by 3%.’ It’s a wonderful goal, but there’s one minor problem: You can’t do it. We’ve been doing industry research for 30 years. We go back and look at payroll as a percentage of sales 30 years ago and today. We can do it in any distributor industry, and we find that it’s the same number.

“Payroll as a percentage of sales today is the same as 30 years ago. I find that amazing, particularly in regard to how sophisticated we’ve become. We used to keep inventory records on 3x5 cards. Today we have technology. We schedule trucks and people better than we used to. We use bar-coding. That technology has done nothing for us in terms of payroll. Payroll is not going to go down via productivity. Payroll is going to go down via us developing a plan to make sure it goes down. I need to have sales grow faster than payroll.”

Sales alone is not the answer, he said. In his fictional company, there is a 2% sales-to-payroll wedge. With 15% sales growth, the profit is $655,000. With 5% sales growth, it’s $605,000.

“You’re sitting there saying, $655,000 is bigger than $605,000,’ ” he said. “It is not exact, but it’s pretty darned close. But it’s not sales that drives it. It’s sales in relation to payroll. Sales volume by itself does not mean anything. It is, how much payroll do you have to buy off to generate those sales?

“Fred is a problem. He’s been with you 20 years—and stopped working 18 years ago. He’s a nice guy. But he’s just not producing. When you have a non-producer, this gap between sales growth and payroll can go backwards.

“In distribution in general, over the last 20 years we have not reduced payroll as a percentage of sales. We end up 20 years later saying we haven’t made an improvement. It is life and death. This is the most difficult of all factors. It is also the most precise. Every firm, regardless of structure, should have the ability to reduce that gap.

“We should replace sales growth with sales-versus-payroll growth. That’s a big change. The tendency is not to think about them at the same time. The sales manager worries about sales, the operations manager worries about payroll. I need to combine those together.

“Gross margin is the steepest rise we had that drives ROA. There’s a tendency to feel in today’s environment that we have to find a way to make it up with volume: ‘Everybody cutting price. I’ve got to cut price also.’ ”

Fool’s game

Bates said that in order to cut the price by 5%, a company would have to do about 22% more physical volume (not dollar volume).

“That’s a 27% increase you have to have in dollar volume,” he said. “In this industry, with the existing structure, you cannot make it up with volume. Everybody likes to talk about Wal-Mart. If you’re going to that route, you have to cut expenses. You have to take expenses and chop them. Most of you do business in a certain way and you can’t make it up with volume in the existing network. It’s a fool’s game.”

He said that if a company raises its price, it’s in deep trouble if the volume goes down even a little bit. A company has to figure out a way to get control of pricing and drive pricing improvements in the business.

“We need to change the way we think about pricing,” he said. “We must drive a higher gross margin through the existing business. That’s going to require gaining control of slow-selling items and building additional margin in them.”

Here’s his mandate for change during each of the next five years: net sales up 5%, gross margin percentage up 0.2%, sales-to-payroll gap up 2%, other-expenses percentage down 0.2%, inventory turnover and collection period unchanged.

“Those are not easy goals,” he said, “but every one of those is small. If I can do them together simultaneously and do them for five years in a row, I think I can change my business.”

The impact of making the mandated changes: If net sales were $20 million in 2013, the ROA would be 6.7%; $21 million in 2014 would produce 8.6%; and $25.5 million in 2018 would produce 15.9%.

“That’s a goal,” he said. “That’s something to think about. I want gross margin of 32% to go to 32.2%, 32.4%, 32.6%, and end at 33% in 2018. It’s bite-size chunks. You can do every single bit of that if you price those slow-selling items more effectively because people don’t really almost care what their price is. It’s a great value added. Profit goes from $500,000 in 2013 to $689,000 in 2013 to $1.6 million in 2018.”

Bates’ theme song is, “Little Things Mean a Lot”—written by Edith Lindeman (lyrics) and Carl Stutz (music). The best-known recording, by Kitty Kallen, reached #1 on the Billboard chart in 1954.

Some of the lyrics go like this:

Give me your arm as we cross the street
Call me at six on the dot
A line a day when you’re far away
Little things mean a lot
Don’t have to buy me diamonds or pearls
Champagne, sables, and such
I never cared much for diamonds and pearls
‘cause honestly, honey, they just cost money
Give me a hand when I’ve lost the way
Give me your shoulder to cry on
Whether the day is bright or gray
Give me your heart to rely on
Send me the warmth of a secret smile
To show me you haven’t forgot
That always and ever, now and forever
Honey, little things mean a lot

“It’s true in romance, I hope,” Bates said. “It’s also true in finance. If you can make some small changes, you can drive a heck of a lot of profit in your business.” ♦

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