The Four Critical Variables Impacting Your Profitability

Dr. Albert D. Bates | Oct 07, 2013

The last few years have been one of the most challenging periods ever in terms of consistently producing adequate profits. Managers had to operate in a period of sharp economic decline and pessimism, followed by several years of anemic growth.

Only recently has the economic picture appeared to improve fundamentally. But even now, there is concern that things may not be as stable as they seem.

Interestingly, throughout the ups and downs, some firms produced much higher profit than the average firm during every year. It wasn’t that the more successful firms were in easier market areas or enjoyed some unique advantage.

Quite the contrary. The most successful firms did very few things better than the typical firm. They also did them just a little bit better than average. In addition, they did them a little better every year. Over time, they have built a strong financial advantage.

The CEDIA financial Benchmarking Survey provides some key insights into exactly how the high-profit firm generates those better profit numbers. The report provides clear evidence as to how small differences in a few areas translate directly into higher levels of profitability.

Typical Versus High-Profit

The typical firm in the survey is the firm with financial performance in the exact middle of the results for all participating firms. That is, on any given measure, half of the firms performed better than the typical firm and half performed worse. It is the best measure of industry performance on any of the profit drivers.

In 2012, the typical firm generated sales of $901,944. On that sales base, it produced an owners’ discretionary profit of $104,625, which equates to a profit margin of 11.6% of sales. Stated somewhat differently, every $1.00 of sales resulted in 11.6 cents of owners’ discretionary profit. The results are good, but not quite as strong as they should be.

In contrast to the typical firm, the high-profit firm generated an owners’ discretionary profit margin of 18.8%. This means that even if the high-profit firm had produced the same sales volume as the typical firm, it would have generated more profit for reinvestment in the firm. This additional asset base produces a multiplier effect over time. More profit leads to a strong asset base, which supports more sales for even greater profit.

Luckily, high-profit performance is open to any firm willing to take proper action. There are no barriers to success in the industry. The only requirement is to identify the areas where the high-profit firms perform better and to target for that level of performance.

Managing the CPVs

To reach high-profit performance, the firm has to focus on what really matters. In benchmarking terms, the important items are called the critical profit variables (CPVs). While the CPVs tend to remain the same over time, their relative importance tends to vary somewhat. The CPV results for the typical firm and high-profit firm in the industry are summarized in the table below.

To a certain extent, some of the differences on the CPVs between typical and high-profit may appear so small that they don’t deserve management attention. However, it is exactly these small differences which multiply to produce major changes in profit margin. This means the typical firm doesn’t have to dramatically improve performance in the CPVs, but simply do a little better across the board.

From a management perspective, it is not even necessary to do a little better everywhere. No firm produces superior results for every single CPV in either good times or bad. Successful firms manage their CPV performance to maximize overall profitability. This is also great news for the typical firm. Perfection is not required, only blending the CPVs in a positive way. With such blending, profit rises significantly.

The CPVs which are the most important to enhancing profit results are sales growth, gross margin, payroll expenses and non-payroll expenses. Each of the factors needs to be planned carefully to ensure adequate profits.

1. Sales Growth

The level of sales growth is always a key issue in generating adequate profits. However, there is a misunderstanding that very rapid sales growth is required for success. Nothing could be further from the truth.

The so-called ideal rate of sales growth equals the rate of inflation plus two to five percentage points. Consequently, if the inflation rate is 2.0%, then ideal sales growth would be in the 5.0% to 8.0% range. This should be viewed as a minimum. Firms may well grow faster, but without basic growth, profit improvement is very difficult.

Sales growth that is too slow means that expenses, which tend to be tied closely to inflation, outpace the rate of growth so that expenses as a percent of sales increase. Sales growth that is too rapid is also a problem. Financing rapid growth is always a challenge, and operating systems tend to get overburdened when growth is rapid.

The reality is that almost no firm will ever turn down a rapid rate of sales growth. However, firms should be aware that while sales growth solves a lot of problems, very rapid sales growth tends to create as many as it solves.

2. Gross Margin

Price pressures never go away, even as the economy recovers. In a down market, firms are too anxious to cut prices to hold sales volume. In an up market, the euphoria over increasing sales tends to reduce the diligence that should be placed on pricing.

In almost every industry, an adequate gross margin is a major determinant of profitability. The real driver behind improved – or at least maintained – gross margin performance is continual monitoring. The inevitable “one-time” deals must never become the norm of operations.

3. Payroll Expenses

Payroll is by far the most important expense factor, which means that controlling payroll is essential to controlling expenses. Interestingly, the high-profit firms have higher payroll costs as they pay their people slightly more for better performance. For both the typical and high-profit firms, there is still work to do with regard to payroll.

Payroll is an area where a specific improvement goal can be established. Ideally, payroll costs should increase by about 2.0% less than sales. For example, if sales increase by 5.0%, then payroll should only be allowed to increase by 3.0%.

This would appear to be a relatively simple target, but the reality is that payroll is the most difficult of all the CPVs to control. The 2.0% goal always proves challenging.

4. Non-Payroll Expenses

Most non-payroll expenses usually require only minor adjustment if sales really are rising faster than inflation. The lion’s share of non-payroll expenses is linked directly to inflation. Controlled growth should keep them in line.

Moving Forward

The high-profit firms produce great results virtually every year. They also reflect the fact that there are no industry barriers to success. The key to improved performance is to develop a specific plan for each of the CPVs and combine them in a positive way.

The goal is not perfection. The goal is to do a little better across the board. Firms must remember that the little things mean a lot.