Part 1: Gross Profit Isn't All It's Cracked Up To Be!
In a recent Supply House Times issue, I found a test offered by the ASA Education Foundation which was meant as a primer on fundamentals of financial and operational issues. ( See “A Quiz For Your Sales Team,” Supply House Times, March 2009.) I took the test, went on the Web and got most of the answers right, musing that my two decades of experience and research into distribution markets wasn’t totally wasted. Plus, it was good to see that an association tries to grapple with issues of profitability, its nuances and definitions. Several of the questions centered on gross profit, net profit and the relationship between the concepts.
From a financial accounting standpoint, the answers were logical. However, the problem I have with the test is that the more I view financial accounting and concepts, the more I am convinced that they are antiquated and can, in a very real sense, cause distributors to deplete profits rather than increase them. One of the largest and most dangerous concepts in distribution is the drive for margin dollars or gross profit, and I’ll spend the rest of this article explaining why the concept is problematic and overrated.
Gross Profit, Period Accounting and Financial MetricsLooking at a typical distributor income statement, one can quickly see that, first, the cost of goods is the single largest cost in the business and far exceeds other downstream costs. Second, the business is a razor thin profit enterprise with average earnings hovering around 2% of sales. So the strategic impetus behind the accounting logic is to spend considerable time on the cost of goods, managing pricing and driving sales. You won’t find too many wholesalers that don’t focus on gross profit, inventory turnover, sales growth and pricing progress in their measurements and plans. These goals are, in many ways, the result of financial accounting and the concept of the income statement as a picture of how the firm makes money.
I believe, however, that financial accounting and financial statements and ratios are way overused and that distribution has regenerated these concepts through countless presentations on outdated PAR reports and, basically, force of habit.
The problem with the concept of gross profit is that it is based on period accounting or, more specifically, the collection of sales and costs specific to those sales for a period of time. For example, let’s review the finances of a mock distributor I’ll call Old-Fashioned Plumbing Supply (OFPS). For the most recent fiscal year the company had $75 million in sales, $56.25 million in cost of goods, $18.75 million in gross profit and $1.87 million in operating profit. Simple math would give operating expenses at $16.88 million and gross margin percent at 25%.
Typical to the industry, the de-facto math that drives pricing is the understanding that, at a minimum, the firm must make a 25% margin. Hence, we would expect to find pricing heuristics at 25% gross margin or greater. Also, looking at a time period such as a quarter, we would expect that the firm would make a positive profit after $4.22 million dollars (16.88/4) are reached. These numbers are simplistic, but have been used with some slight variations for decades.
Our research, however, finds that the time period concept of income and expenses has significant flaws when it comes to understanding how profits are made and how costs move (behave) under varying market conditions. This is introduced in the next section.
Aggressive Step Costs and Transaction-Based AllocationsLooking at OFPS, the two largest cost buckets are cost of goods ($56.25 million) and operating expenses ($18.75 million). When it concerns impact on earnings, I stress operating expenses. This is often met with a pithy, “Why?”
To most, the sheer size of cost of goods should garner the most attention. However, in my experience, most distributors are well dialed in on their cost of goods. This is a factor of intense purchasing pressure on vendors, the explosion in global sources, and growing and vibrant buying groups.
On the other hand, operating expenses, which are directly controlled by the distributor, offer an under-explored chance for efficiencies and increased earnings. One of the major problems with managing operating expenses is the accounting conventions used to capture them. We are taught, in financial and even managerial accounting, to think in terminology of ledger costs, accounting ratios, cash flows, etc. Unfortunately, these measures are based on the time period(s) in question and the metrics don’t always contain great insight.
For instance, if OFPS spent 4% of sales for their outside sales force and this was compared to an average 3% for similar distributors, is this comparative good or bad? Simplistic analysis would say that OFPS overspends on outside sellers but that doesn’t take into account the positive growth of the sales force. Hence, a simple ratio comparison of sales expense from a PAR report means very little. To get a good understanding of any potential overspend by OFPS would, in my experience, involve considerably more analysis of contribution of a seller’s sales to operating income, territory configuration, call frequency, segment dynamics, and comfort zone of the seller.
Let’s look at another measure from a PAR report, such as gross margin (profit) dollars per outside seller. Suppose OFPS generated $425,000 per outside seller and a competitor generated $500,000. Does this imply, as many would think, that OFPS’ sellers weren’t as productive as the competitor’s sellers? My experience is that margin dollars per seller means pretty much nothing. There is little you can tell from the number and, in fact, it matters little how many margin dollars a seller generates. More important is how their sales contribute to operating profit dollars, but financial accounting as it’s been approached in distribution can’t give you this answer except within a time period. Any seller, transaction, customer or branch detail is not possible.
The problem with margin dollars is that it is one number and not necessarily a good one to judge productivity and manage profitability. That’s because margin dollars consider only the cost of goods and not operating expenses. And financial accounting lumps operating expenses into a time period with no allocation of expenses to sellers, their territories, their customers and their branches.
Distribution is a business classified (at least by me) as an aggressive step cost structure. This means costs rise with volume or “step up” with sales volume. Without understanding how costs “step up,” the distributor is left without valuable information on how to drive operating profit.
In our work, some 75% or so of operating costs rise with volume. To understand what drives operating profit, distributors need some way to allocate operating costs to actionable entities such as sellers, customers, territories and branches to understand where money is made and where it is lost.
The tragedy in distribution is that, after a century of history, there is no agreed-upon standard by which to allocate step costs to entities of the firm to understand if they contribute to operating profit.
Manufacturing, unlike distribution, has long included components of labor, materials and overhead in the cost of goods. But distribution never got around to this in any meaningful and standardized fashion. The results are sub-par profits for distributors and an incomplete understanding of how costs move and what investments really pay off.
Some years ago, I and my associates became disenchanted with the endless PAR reports and Activity Costing gurus. To us, their numbers and methodologies were inaccurate or impossible to use. We looked for a better way to allocate step costs to give insight on what exactly grows operating profits. Our work in the field and research on how to improve operating profits led us to the transaction or, more specifically, transaction type as an underrated but quite accurate entity to use as an allocation model.
I’ll cover transaction cost modeling in our next installment and show how compensating OFPS’ outside sellers on margin dollars has a high probability of actually decreasing operating profits. Until then, consider that margin dollars or gross profit may be a solid accounting concept, but a weak and antiquated metric to drive operating performance in a step-cost intensive business.
This will strike many people as heresy. That’s because the distribution industry as a whole has been reluctant to embrace new research of measures and knowledge. I’ll give some examples and insight into our proprietary work in transaction management and differential costing in the next installment and explain why I believe they are a good start toward better tools to manage profitability.
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