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12/30/2011

Profit Improvement Report: The New Economics of Sales Growth

(Dr. Al Bates, President of Profit Planning Group)

Even after three years of somewhat stagnant sales growth, far too many businesses are still waiting for a return to a buoyant economy to get them back to the good old days of profitability.  Sadly, those businesses are probably doomed to a very long wait.  The "new reality" probably really is the new reality.

At the same time the overwhelming majority of firms, including most NAHAD members, have cut expenses to the point where there doesn't appear to be anything left to cut.  Some level of additional sales volume is essential to generate desired profit levels. 

These two conflicting realities—the lack of automatic sales volume growth and the fact that sales volume growth is essential to success—combine to put firms into a serious financial bind.  In order to get out of that bind, firms must begin to look at sales volume in a different way. 

This report will suggest that the sales growth required for success is readily accessible.  It will do so by looking at two different issues.

The Sales Growth Requirement—An analysis of how to set a realistic goal for sales growth and its implications for the firm.

Sales Growth Generation—An examination of the new requirements that are incumbent upon all firms to achieve high levels of profitability.

The Sales Growth Requirement
One of the most common misunderstandings about improving profit is that a rapid rate of sales growth is essential.  The reality is that rapid sales growth is not essential; it simply makes life a lot easier.  With just modest sales growth, it is still possible to increase profits.  This should be excellent news for firms somewhat fatigued by a sluggish economy.

Please note very carefully that when there is no sales growth at all it is virtually impossible to produce higher profits.  Some modest level of growth is required.  The challenge is in defining modest.

Exhibit 1 examines the economics of growth by reviewing the financial performance of the typical NAHAD member as reported in the latest IPR Report. 

As can be seen in the first column of numbers, the typical firm generates sales volume of $8,000,000, has a gross margin equal to 38.0% of sales and generates a pre-tax profit of $360,000, or 4.5% of sales.  Results are adequate, but unexciting.

The last two columns of numbers in the exhibit starts with one overwhelming principle:  sales growth must at least equal the rate of inflation rate plus 2.0 to 3.0 percentage points.  This is not arbitrary.  It is the level that historical results suggest is required.

In this specific example the underlying inflation rate is assumed to be 2.0%.  Adding 3.0 percentage points to that rate results in a target sales growth rate of 5.0%.  However, the two columns produce very different profit levels with the same exact 5.0% increase in sales.

Internally Focused Growth—In the second column the sales increase has come from internal sources.  In simplest terms, the firm is selling existing products to existing customers.  Such sales growth does not require additional staff in the short run.  However, payroll increases almost always outstrip the inflation rate, so they are assumed to increase by 3.0%.  In contrast, non-payroll expenses will probably at about the same rate as inflation, or 2.0%.  As a result, pre-tax profit jumps from $360,000 to $440,800, an increase of 22.4%.

Externally Focused Growth—The final column assumes that the sales increase is generated via external sources, namely new products and/or new customers.  Research conducted by the Profit Planning Group across more than 100 lines of trade for over thirty years has demonstrated that that the reliance on such sales sources produces a significant increase in expenses.

The last column assumes that payroll costs increase by 7.0% and non-payroll costs increase by 3.0%.  Again, these are consistent with historical patterns associated with external sales growth.  The result is that sales increase by the same 5.0% as in the second column, but profit increases by a miniscule 0.3%.

The challenge is that in a slow-growth market every firm is looking for external sales growth.  There is a feeling that the market is not growing fast enough to support the required growth goal of inflation plus 2.0 to 3.0 percentage points.  In fact, virtually every firm can capture such growth with a structured effort.

Sales Growth Generation
Obviously, growing sales by even a modest 5.0% when the market is only growing by, say 2.5%, is far from automatic.  However, it is a goal that can be reached by committing to three specific strategies.

Letting Inflation Work—Over time prices head north in all but a very few unique industries (think consumer electronics).  Vendor price increases are actually the NAHAD member's best friend.  Unfortunately, they are almost always viewed with disdain if not outright contempt.

The problem is that in a tight economy there is a temptation for firms to absorb portion of supplier price increases.  Instead, there must be a mentality in the firm that  every 2.0% price increase from suppliers must result in a corresponding 2.0% price increase to customers.  This will usually keep sales growth in line with inflation.  That still leaves 2.0% to 3.0% to cover to get to 5.0% growth.

Controlling Internal Economics—Growing faster than the inflation rate means the firm must begin to gain share.  This is where the internal focus becomes absolutely critical.

Increasing the average transaction size, largely by adding more lines to each order, is the essence of an internally-focused sales generation strategy.  By definition, if the firm can put more lines on every order, competition is getting fewer of those lines.

To fully implement the strategy, the firm must measure, monitor and control the average order size and the number of lines per order.  Without such a measuring system, improvement cannot become a reality.

Sales Force Discipline—In a rapidly-growing market, firms can allow under-performing salespeople to stay with the firm for the sake of employee morale, team spirit and the like.  In a slow-growth market, poor-performing salespeople are a luxury that can no longer be afforded.

Sales training must be emphasized at the rear end of the sales parade.  Coaching and changes in compensation systems (lower base, more incentive compensation) are also essential. Ultimately, if adequate sales can't be generated, a change in personnel must be considered.  Finding and training a new employee is an expensive proposition, but keeping an under-performing one is even more expensive in terms of sales and margin not generated.

Moving Forward
Automatic increases in sales fueled by a vibrant economy are not going to be a reality anytime soon.  Firms must develop ways to turn slow sales growth into rapid profit growth.  Doing so requires a commitment to focus much more heavily on internal sales growth.

A Managerial Sidebar:

All Salespeople Are Not Equal

The so-called 80/20 rule applies to the sales force as well, although in a much stronger fashion.  Research suggests that the top 10% of the sales force will typically produce about 50% of the firm's sales and 80% of its profits.  In most instances firms are highly reliant upon the top salespeople to shoulder the sales load.  These folks also tend to be prima donnas.

At the other end of the spectrum, the bottom 20% of the sales force usually generates only about 5% of sales.  Of much greater significance, they produce a loss equal to about 20% of the firm's total profits.

About the Author:

Dr. Albert D. Bates is founder and president of Profit Planning Group.  His latest book, Triple Your Profit! is available at:  www.tripleyourprofitbook.com.

©2011 Profit Planning Group. NAHAD 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.