August 2003                       return to the newsletter contents page

The High Profit Performers: 

How Do They Do That?

The 2003 SEDA PROFIT Report indicates some major differences between the performance of the typical firm and the high-profit firm. Of them all, the difference in return on assets is most striking.

Return on Assets (ROA) is the single most valuable measure of a company's overall performance. The ratio measures the economic viability of the firm. Companies that cannot produce an adequate ROA face an extremely difficult future.

Return on Assets

ROA is simply profit before taxes expressed as a percentage of total assets or total investment. Exhibit 1 includes a comparison of the ROA performance for the typical SEDA member and the high-profit one. As can be seen, the typical firm has an ROA of 

1.7%. This means that every dollar invested in the firm produces a pre-tax profit of 1.7 cents. 

In sharp contrast, the high-profit members of SEDA produce an ROA of 8.0%. Every dollar of asset investment produces a return of 8.0 cents in profit before taxes. For a company with $10,185,391 in sales, the difference is a profit of just $50,927 for the typical SEDA member versus $234,264 for the high-profit firm. It is a performance gap that every firm should attempt to close.

In planning improvements in profitability, return on assets can be broken down into two key components—profit margin and asset turnover. Each of these ratios has its own implications for the firm.

Profit Margin

In the most basic terms, this is the bottom line. The ratio indicates what percentage of each dollar of sales becomes profit as measured by net profit before taxes to net sales. The better performing firms primarily differentiate their performance in this area.

For the typical firm the pre-tax profit margin was 0.5%. In contrast, the high-profit firm produced a bottom line of 2.3%. Most of the effort in improving profitability should be geared towards profit margin. This will include factors such as the gross margin percentage on sales and the level of operating expenses on those same sales.

Asset Turnover

This indicates the asset investment required to support the current level of sales, as measured by net sales to total assets. For the typical firm the asset turnover ratio was 3.5. This means the firm generated $3.50 in sales for each $1.00 invested in total assets. For the high-profit firms, the ratio was also 3.5.

Asset turnover is usually only a minor factor in improving return on assets, but is extremely significant in cash management. Controlling asset turnover relies very heavily on increasing inventory turnover and improving accounts receivable collections.  

In improving both profit margin and asset turnover, and ultimately return on assets, it is necessary to identify the factors that really drive profitability. In financial parlance, these are often referred to as the critical profit variables.

The Critical Profit Variables

One of the prevailing myths about high-profit firms is that they do everything better than the typical firm. Not only that, they do them a lot better. The reality is exactly the opposite. The high-profit firm inevitably does only some things better 

than the typical firm. In addition, they do them only a little better. The challenge is in identifying what they do better and why these factors are so important in generating higher profits.

Exhibit 2 reviews the critical profit variables. These are the factors that year in, year out appear to drive profitability within the industry. Firms should focus on these factors relentlessly.

Interestingly, there are only six critical profit variables. Even with this small number of factors, no firm is perfect. Instead, the most successful firms tend to fit the critical profit variables into a model that creates improved results for their firm. The challenge is in knowing how to build the model for your firm.

Sales Growth

Over the long haul, the high-profit firm grows faster than the typical one. This is because sales growth allows the firm to offset operating expense increases that occur almost every year. With adequate sales growth, the firm can offset inflation and provide greater customer service.

The high-profit firm does not usually produce higher sales growth every single year. They simply produce higher sales growth most of the time. As Exhibit 2 indicates, in 2002 the typical firm had sales growth of -1.9%. In contrast, the high-profit firm had a sales growth rate of -0.1%.

Gross Margin Management

Gross margin has a huge impact on profitability. Getting the margin right takes the pressure off of other operating areas of the business. Once again, from a long-term perspective the high-profit firm tends to have a superior gross margin percentage to the typical firm. However, this is not an absolute every year.

For the typical SEDA firm, gross margin was 26.4% of sales in 2002. That is, every dollar of sales volume generated 26.4 cents of margin to cover operating expenses and produce a profit. At the same time, the high-profit firm had a gross margin of 26.3%.

Payroll Expenses

For SEDA members, payroll is by far the most important expense factor. Controlling payroll is essential to controlling expenses. There are numerous ways to measure payroll effectiveness, including sales per employee and payroll as a percent of sales. Increasingly, firms are looking at the Personnel Productivity Ratio—the PPR.

The PPR measures the percentage of every gross margin dollar that must be devoted to payroll and fringe benefits. Computationally, it is simply payroll and fringes divided by gross margin. Strategically, it measures how much it costs to produce the value the firm provides to its customer base.

For the typical firm the PPR is 63.3%. That is, payroll costs the firm 63.3 cents of every gross margin dollar. The high-profit firm operated on a PPR of 61.0%. An improvement in the PPR should also produce an improvement in the profit margin position.

Non-Payroll Expenses

In analyzing non-payroll expenses, firms typically utilize expenses as a percent of sales. For SEDA members non-payroll expenses represent 9.3% of sales for the typical firm and 8.1% for the high-profit one. Controlling non-payroll expenses involves examining literally every expense category in the hope of making modest improvements in a number of areas.

Controlling the Investment Base

Accounts receivable and inventory make up 78.6% of the total assets of the typical SEDA member. Therefore, the level of asset utilization achieved by the firm is highly dependent upon controlling these two factors. This leads to a concern with both inventory turnover and accounts receivable collections.

Inventory turnover is a factor the high-profit firm often performs better on than the typical firm. However, in many years they do not, depending upon how inventory is being used to back up product expansions, the addition of new territories and the like.

In 2002, the typical firm had an inventory turnover of 6.2 times, which means they turned their inventory every 58.9 days. In comparison, the high-profit firm had an inventory turnover of 7.7 times which required an inventory investment of 47.4 days. Improvements in inventory turnover have a modest profit impact but significant cash flow implications.

The average collection period for the typical SEDA firm was 40.7 days in 2002. In comparison, the high-profit firm had an accounts receivable investment of 41.1 days. As with inventory turnover, the major impact of shortening the collection period is on cash flow.

Summary

At present there is a significant gap between the typical and the high-profit firm with regard to return on assets. If the typical firm is to move towards high-profit, it must identify exactly how the successful firm produces superior results. In doing so, it must re-examine the Critical Profit Variables and set specific benchmarks for each measure. Without such planning, high-profit performance will always remain an elusive target.