Expense Leveraging And Gross Margin Management

Focusing on the Big Two will reap rewards.

One of the more interesting aspects of management is the degree to which extremely small changes in key areas of the business result in large changes in overall profitability. In point of fact, the differences between the very top firms in GAWDA’s annual Profit Report and the lower-profit firms is a matter of doing just a little better on a few critical factors.

The difficulty in driving the “philosophy of small changes” throughout the business is that there are lots of different areas where such changes are possible. In reality, though, there are only two fundamental issues that management needs to address from a financial perspective. These issues are expense leveraging and gross margin management.

Improvement Goals and Their Profit Impact
The link between small changes and large improvement is outlined in Exhibit 1. The first column in the exhibit presents results for the typical GAWDA member based upon the latest Profit Report. As can be seen in the exhibit, the typical firm generates sales of $15,000,000, operates on a gross margin of 43% of sales, and produces a pre-tax profit of 6% of sales, or $900,000.

The Financial Impact of a Combination of Gross Margin and Expense Leveraging

 

The final column of numbers in the exhibit identifies the profit impact of focusing on expense leveraging and gross margin management. The exhibit incorporates some highly specific goals for GAWDA members which need to be well understood. There are three areas in which changes have been made:

  • Sales: The sales growth factor used in the exhibit is 5%. However, any level of growth could have been used, either positive or negative. The 5% figure represents the modest performance demonstrated in many mature industries during periods of normal economic activity. The point is that rapid growth is not required for profit improvement.
  • Gross Margin: This is the impact of 2% more margin dollars on whatever level of sales volume is generated. This is not the same as increasing the gross margin percentage by two percentage points. Instead, the new gross margin figure is the new sales volume (which has increased by 5%) times the existing gross margin of 43%, then adding an additional 2% more margin dollars. The result is that the gross margin increases from 43% of sales to 43.9%.
  • Expenses: The basic concept of expense leveraging is to manage the expenses so they grow at a slower rate than sales. In the exhibit, two different leveraging rates have been used. While sales have grown by 5%, payroll has grown by 3% and other expenses by 2%. This reflects the reality that payroll expenses (including all fringe benefits) are more difficult to control than non-payroll expenses.

The impact of these changes is dramatic. Profit before taxes increases from $900,000 to $1,211,950, an increase of 34.7%. In short, a concerted effort on making small changes in the big two can provide a significant improvement in overall profitability.

The specific figures used in the exhibit, such as 2% more gross margin, are not necessarily recommended as goals for all GAWDA members. Every firm has its own unique set of economics which requires company-specific goals. However, they are suggested as starting points in each firm’s planning process. In most cases, realistic targets for GAWDA members should be relatively close to the illustrative figures used in the exhibit.

It is important to note that inventory and accounts receivable are conspicuous by their absence in the analysis. This does not mean that these are not important elements of the business. It does suggest, however, that improvements in inventory and accounts receivable control are not required.

If performance in these two areas can be maintained at existing levels, the focus on margin and expense leveraging will be sufficient for profit improvement. Conversely, if improvements in either gross margin or expense leveraging are possible, profit enhancement will be extremely difficult.

Implementation Challenge
Plans are wonderful. They’re a roadmap that helps firms see how to get where they need to go. A detailed, easy to understand plan is particularly valuable as it readily translates into understandable terms for employees. Understandable plans are more likely to be achieved.

However, even the best plan does not ensure success. From an implementation perspective, firms need to do two specific things. First, they need to educate employees on the reason for these changes. Second, they need to translate the overall goals into action items for all employees.

Financial education of employees is essential, but frequently ignored. The problem is that without a basic understanding of what happens in a business from a financial perspective, change is misunderstood. For example, most employees believe that if gross margin is increased by 2%, profit will increase by the same 2% figure.

The second implementation challenge is that the overall goals—in terms of both margin and expense planning—must be translated into a plan for each individual in the firm. In essence, every employee needs to know specifically what to do and how it contributes to realizing the overall company goals and objectives.

If sales must be increased by 5%, then that needs to be translated into the number of additional order lines that the sales force has to produce each week, or the increase in the service level that must be achieved, or the number of potential new accounts that must be contacted. Then it is necessary to demonstrate the potential cumulative impact on profits. Only when employees have precise marching orders and an appreciation for their impact can the company move toward the improved performance goals.

Moving Forward
If GAWDA members are going to reach higher levels of profitability, it is essential that they develop improvement plans in two areas: gross margin and expense leveraging. In addition, they must ensure that every employee understands how individual actions will help make the improvements a reality.

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 www.profitplanninggroup.com.