Making It Up With Volume

Most GAWDA members continue to operate under price pressures. Even though the economy has turned up, there is a relentless push by gases and welding customers for an extra discount. Far too many firms simply lower the price and move on.

This report will examine two key issues with regard to the price/volume relationship:

  • The Sales Volume Challenge—Measurement of the volume increase required by the typical GAWDA member to offset a price decrease.
  • Holding the Line on Prices—Suggestions regarding specific procedures for holding the line on price.

The first of these is extremely quantitative. It demonstrates quite clearly the futility of chasing additional volume. The second is much more qualitative in nature. It probes the areas of action that are likely to have the largest payoff in controlling price reductions.

The Sales Volume Challenge
Far too many decision makers view price cutting benignly or even favorably. In part this is a function of the continual pressures on margin faced by firms every day. If everybody is asking for price reductions, the concept becomes a way of life. It is also due to the fact that some firms that have successfully used price as a competitive tool. In particular, Wal-Mart and Dell Computer are commonly presented in the business press as role models for success.

The truth is that GAWDA members face a very different cost structure than either Wal-Mart or Dell. The unique structure of expenses in the industry makes it extremely difficult to employ price cutting successfully without a significant change in operations.

Exhibit 1
The Change Required in the Firm’s Financial Results
to Exactly Offset a Price Reduction
  Current
Results
5.0%
Price
Reduction
Percent
Change
Net Sales $8,000,000 $8,679,012 8.5%
Cost of Goods Sold 4,400,000 5,024,691 14.2%
Gross Margin 3,600,000 3,654,321 1.5%
Variable Expenses 640,000 694,321 8.5%
Fixed Expenses 2,640,000 2,640,000 0.0%
Total Expenses 3,280,000 3,334,321 1.7%
Profit Before Taxes $  320,000 $  320,000 0.0%


Exhibit 1 looks at the operation of the typical GAWDA member. According to the most recent GAWDA financial benchmarking survey, this firm generates $8,000,000 in sales volume, operates on a gross margin of 45.0% and produces a pre-tax profit of $320,000, or 4.0% of sales.

In addition, the firm has both fixed and variable expenses as part of its financial profile. Fixed expenses represent the commitments that must be made so that the firm can conduct business, including rent, maintenance and related expenses. It also includes virtually all salaries and associated fringe benefits.

In sharp contrast, variable expenses represent the incremental costs of generating additional sales. Typically, these will include sales commissions, bad debts, bankcard charges, overtime and some interest expense.

Fixed and variable expenses can be estimated reasonably from the GAWDA financial benchmarking survey. Variable expenses are assumed to be 8.0% of sales, or $640,000. All of the remaining expenses, $2,640,000, are fixed.

The first column of numbers in Exhibit 1 indicates where the typical firm is at present. The second column demonstrates the impact of a unilateral 5.0% price cut. That is, it does not reflect a 5.0% price cut by suppliers and a simultaneous equal price cut by the GAWDA member. Instead, the firm has made the price cut across the board to its customers absent any inbound reduction from suppliers.

The key to the second column is that it reflects how much additional sales would have to be generated by the firm to hold profit where it is now, namely $320,000. The sales requirement is nothing short of daunting. Sales must be increased to $8,679,012, an increase of 8.5%.

The exhibit makes two assumptions. First, the firm cannot buy any more effectively as it increases its sales volume. Second, the firm can increase its sales volume by 8.5% with no increase in its fixed expenses.

When the two assumptions are combined, the exhibit could probably be characterized as somewhere between neutral and overly optimistic as to the benefits of sales volume. In either case, the exhibit indicates that it will take a massive increase in sales to overcome the price reduction.

The exhibit looks at one specific situation; a 5.0% price reduction. In some situations, even larger price reductions may be considered. It is extremely important to be aware that each successive increase of the same 5.0% increment produces a larger required sales increase than the previous price reduction. This is reflected by the following results that indicate the increase in dollar sales to once again produce $320,000 in profit.

Percentage Price Reduction Required Percentage Increase
in Dollar Sales to Maintain Profit

  5.0
10.0
15.0
20.0

  8.5
19.8
35.6
 59.1


As can be seen, a 5.0% reduction requires an 8.5% increase in sales to maintain profit at the $320,000 level. However, when the price increase is doubled to 10.0%, the required sales increase more than doubles. There is an accelerating rate of required sales increases. At some point, even the most optimistic manager must come to the conclusion that there is a point where price cutting simply cannot be effective.

Holding the Line on Pricing
Understanding the challenges associated with price cutting can create a proper mindset for pricing. However, it doesn’t make the competitive world any easier. Creating an environment of price integrity within the firm requires three specific actions:

  • Sales Force Controls — The sales force is continually bombarded with requests to lower prices. Ultimately, the course of least resistance becomes inevitable, even among the very best sales personnel. Specific controls are necessary to help maintain price discipline. Such controls usually come in the form of absolute minimum price levels or sliding commission scales.
  • Margin Enhancements — Most of the severe price competition is focused on the commodity end of the product line. At the slow-moving end of the assortment there are numerous opportunities to build margin back. There should be no hesitation in doing so in instances where product availability on slow sellers is a major value being added.
  • Employee Education — There is sometimes the tendency to view the pricing challenge as being entirely the responsibility of the sales force. In point of fact, numerous employees impact margin in actions ranging from buying more effectively to controlling damaged goods and shrinkage. Every employee needs to be aware of the margin issue.

Moving Forward
Price pressures are not going to go away any time soon. To continue to be successful, GAWDA members must make sure that every decision maker in the firm understands the impact that price cutting has on performance and the rather massive sales increase that it mandates.


Calculating Volume Sensitivity
It is possible to calculate the volume sensitivity to price cutting for a specific firm using a seemingly complicated, but actually straightforward formula. The formula can be calculated with Microsoft® Excel. The specific formula is:
                                           Fixed Expenses $ + Profit $                                          
{ (GM % – Price Cut %) / (100% – Price Cut %) } – Variable Expense %
 
For the typical GAWDA member discussed in the text, the calculation is as follows:

     Fixed Expenses $           +               Profit $            
{GM%    –   Price Cut %}     –     Variable Expense %
{100%    –   Price Cut %}                                          

Equals

          $2,640,000               +           $320,000            
     45% – 5.0%                –               8.0%         
100% – 5.0%                                             

Equals

                                $2,960,000                                
 40.0%  /  95.0%            –               8.0%         

Equals

                                $2,960,000                                
34.1%

Equals

$8,679,012

 

The resulting figure represents the sales that must be generated at the reduced prices to continue to produce $320,000 in profit.


Gases and Welding Distributors Association
Al Bates Meet the Author
Albert D. Bates, Ph.D. is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.