Remembering The Mistakes Of The Past

Payroll pressures tend to appear in the second year of recovery.

Gases and welding distributors are about to test the accuracy of George Santayana’s famous quotation: “Those who cannot remember the past are condemned to repeat it.” More likely than not, the results of the test will not be pretty.

The economy has just emerged from a rather ugly recession, just as the economy has emerged from recessions numerous times in the past. Time after time, distributors have made the same mistakes during the recovery. With planning, those mistakes really should be avoidable this time.

The Traditional Mistakes
In every recovery, far too many distribution executives make the same mistakes. They don’t make them because of a lack of experience; many managers have already experienced these challenges once or twice. They make them because the pressures that recur automatically at the beginning of every recovery period are almost impossible to resist. Those three mistakes are uncontrolled growth, payroll expense pressures and excessive inventory investment.

Uncontrolled Growth — Suggesting to any manager at the end of a recession that there can be too much growth is a sure way to be heaped with ridicule. The worse the recession, the more surely the recovery is greeted with the sales manager’s adage that sales growth solves all problems. Actually, sales growth both solves and creates a number of problems.

The major problems associated with excessive sales growth are operational in nature. Sharp sales increases place a severe strain on the staff. Out-of-stock situations arise, errors in the warehouse and shipping multiply, and customer complaints begin to be heard.

Three Simple Guidelines for Sales Growth
  1. Give primary sales support to customers who were loyal during the recession.
  2. Hold the line on margins. Far too much of the “incremental sales growth” during the recovery is lower margin activity that may or may not help profits.
  3. Track key operating ratios, such as lead time on outbound orders and service level.

No firm is going to say no to additional sales. However, every firm should follow three simple guidelines with regard to sales growth. First, give primary sales support to those customers who were loyal during the recession. Second, hold the line on margins. Far too much of the “incremental sales growth” during the recovery is lower margin activity that may or may not help profits. Third, track key operating ratios, such as lead time on outbound orders and service level, very closely. Even modest reductions in performance are often the precursors of poor profit results.

Payroll Expenses — Interestingly, the payroll problem does not occur during the first year of recovery, it develops during the second year. The problem is also directly associated with Fred.

Fred is a loyal and hard-working employee who has been with the firm many years. Fred has a family. Fred has not had a significant pay increase in a couple of years because of the recession. It is time to help Fred catch up. When that occurs, Fred will win and company profits will lose.

Payroll must be matched against sales and margin, in good times and in bad. Because of the importance of this issue, an entire section of this article will be devoted to covering it in greater detail.

Inventory Investment — During the downturn, cash flow pressures typically cause distributors to lower inventory. When sales start back up, out-of-stock situations frequently arise. The inevitable result is a rush to replenish inventory. Too often, inventory levels grow in an uncontrolled manner.

The frequent result is a severe cash flow strain. At the very time the firm is beginning to produce higher sales and stronger profits, cash balances begin to fall precipitously. Inventory investments need to be focused in product areas where they produce additional sales.

A Planning Perspective
The enthusiasm of the recovery needs to be tempered with a commitment to planning. This need applies to the entire business. However, the challenges can be seen most directly in the payroll area, so that will be used as the focus of the discussion.

Exhibit 1
The Impact of a 5% Increase in Sales
and Various Increases in Payroll
4% Payroll
5% Payroll
6% Payroll
Net Sales $8,000,000 $8,400,000 $8,400,000 $8,400,000
Cost of Goods Sold 4,264,000 4,477,200 4,477,200 4,477,200
Gross Margin 3,736,000 3,922,800 3,922,800 3,922,800
Payroll & Fringe Benefits 2,120,000 2,204,800 2,226,000 2,247,200
All Other Expenses 1,328,000 1,394,000 1,394,000 1,394,000

Total Expenses

3,448,000 3,559,200 3,620,400 3,641,600
Profit Before Taxes $288,000 $323,600 $302,400 $281,200
Profit Margin 3.6% 3.9% 3.6% 3.3%

As was mentioned earlier, payroll pressures tend to appear in the second year of recovery. The first year is usually one of making certain that sales really have turned up. During that phase, management remains diligent in controlling expenses. In the second year, the philosophy changes somewhat. Pay increases become easier to justify and efforts to rebuild the employee infrastructure take place. This typically happens just as the large increases in sales are giving way to more modest ones.

Exhibit 1 examines the performance of the typical GAWDA member. The first column presents actual results. The key point is that payroll represents 61.5 percent of total expenses. As payroll goes, so goes the firm.

The next three columns assume a scenario where the firm enjoys five percent sales growth. However, payroll expenses increase by either four percent, five percent or six percent. At the time, other expenses grow at the same rate as sales (five percent), a very typical situation.

As can be seen, if payroll can be controlled (an increase of only four percent), the increase in sales causes profits to rise from $288,000 to $323,600. If payroll grows right along with sales at five percent, then profit increases by the same five percent to $302,400. However, if payroll expense growth is out of control (a six percent increase), profits decrease to $281,200. The firm is in the unenviable position of selling more and making less.

On the surface, the difference between a four percent and a six percent increase appears to be extremely small. The profit impact is huge, however, with a profit of either $323,600 or $281,200 on the same sales volume. The exhibit suggests that even modest miscalculations on sales growth versus expense growth have large implications for the firm. The watchword for the second year of recovery must be conservatism. It is absolutely essential to control payroll in relationship to actual sales growth, not desired growth.

Moving Forward
The recovery should be a time of major profit growth for GAWDA members. Indeed, results reported in the PROFIT Report indicate sharp improvements. Whether those improvements continue depends upon the extent to which firms avoid the inevitable pressures that accompany recovery. Of all the pressures the firm faces, payroll expense growth is by far the most important. It must be the central concern of every manager.

A Managerial Sidebar On Planning Payroll Expense

Given the importance of payroll expense for GAWDA members, it is useful to have a planning mechanism for ensuring that payroll does not get out of control. Such a mechanism involves “working backwards” to determine the level of payroll expense the firm can afford. It should be remembered during the process that payroll expense also includes salaries and all fringe benefits.

  Calculation Current Results Planned Results
1 Net Sales   $8,000,000 $8,400,000
2 Gross Margin %   46.7% 46.7%
3 Gross Margin [ 1 x 2 ] $3,736,000 $3,922,800
4 Net Profit   $288,000 $331,200
5 All Other (Non-
    Payroll) Expenses
  $1,328,000 $1,394,400
6 Allowable Payroll [ 3 - 4 - 5 ] $2,120,000 $2,197,200

The following example uses figures for the typical firm in the industry. The example assumes that sales will increase by five percent, gross margin percentage will remain unchanged and that all other (non-payroll) expenses will grow right along with sales at the five percent level. Of greatest importance, it assumes the firm wants profit to increase by 15 percent.

This analysis could be used with any other set of assumptions as well. The key to making the system work is to ensure that the sales goal is conservative. Given that, payroll can be kept in line despite the enthusiasm of the recovery.

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, and on the Web at