March 2004              return to the newsletter contents page

Watching Your Profits Slip Away

by Dr. Albert D. Bates

SEDA members have made significant strides in recent years in terms of management sophistication. They are using new technology, employing more creative management techniques and analyzing their businesses in more precise ways than ever before. Even so, profits continue to lag.

Part of the problem can be attributed to an economic environment that until recently was

not particularly friendly. However, to a great extent the economic conditions have hidden an important management issue. Despite the advances at the top of the organization, decisions continue to be made at the bottom that systematically erode profits.

The problem stems from the massive number of sales transactions the typical SEDA member must process each year. Each transaction, or order, represents several individual line items. There is simply no way every component of every transaction can be monitored by top management.

This article explores the issue of how profit continues to slip away, usually without even being noticed. It does so by looking at two specific issues:

• Determining the Magnitude of the Profit Reductions—Many of the profit losses are unseen, so it is only possible to develop an appreciation for how profit is undermined. In doing so, the focus will be on the sales force. This is not intended to single out the sales force as a problem area. The intent is to use sales generation as an example of the larger problem.

• Eliminating Profit Erosion—Realistically, the problem of profits slipping away will never be entirely resolved as there will continue to be a massive number of transactions. However, both employee education and better sales tracking can go a long way in reducing the problem.

Determining the Magnitude of the Profit Reductions

There is no line item on the income statement that measures how much profit is lost by ineffective decisions. By their very nature, the losses are invisible, almost defying management to do something about them. Addressing the issue requires that a more detailed analysis of profit be generated within the firm.

By using data for the typical SEDA member it is possible to quantify the potential profit reductions. Based upon the latest numbers available, the typical SEDA firm has the following key operating characteristics:

The thought of simply processing 25,641 orders and 76,923 order lines is daunting enough. The thought of doing so with 100% accuracy in every aspect of the transaction moves beyond daunting to impossible.

Clearly, many of the mistakes that can be made in the transaction process are obvious, particularly in areas such as warehouse operations. For example, if the wrong item is picked and shipped to the customer, the customer complains. The wrong item has to be retrieved and the correct item delivered. Tracking such problems is relatively easy.

However, there is another category of errors that is not quite so apparent. They represent the loss of sales and gross margin when an individual transaction is not handled in an optimal manner.

Exhibit 1 looks at the nature of the unseen slippages by focusing on sales force activity. The first column simply reflects a typical order for a SEDA member. The numbers reflect the results identified above. To be able to analyze results, two important assumptions were made:

• Commissions—These represent 10.0% of gross margin. Commissions are frequently paid based upon margin, but the exact rate depends upon whether or not there is also a base salary and several other issues. The 10.0% figure is being used simply for the ease of computation.

• Other Variable Expenses—These include the cost of financing the transaction, potential bad debts and incremental handling costs. For ease of calculation they are set at 2.6% of sales.

As can be seen at the bottom of the first column, the typical transaction produces a meager profit of only $1.95, which represents the profit margin for the typical SEDA member of 0.5% of sales.

The second column of numbers looks at what happens when the rep does not generate as many items on each order as possible. Specifically, it involves just one less line item per invoice. The impact on profitability of this action is often grossly underestimated. In fact, one less item produces a loss of $25.56 on the entire order.

The final column examines what happens when a three percent price reduction is granted to secure the order. This reflects the fact that price is continually under attack. However, once again the impact on profit is devastating, with a loss of $8.28.

Both of these are real-world situations. With diligence, it is probably possible to pick up most of the major price reductions. However, the vast majority of the minor ones slip by unnoticed. In contrast, the failure to generate as large an order as possible is virtually impossible to control in any situation.

Eliminating Profit Erosion

It will never be possible to completely capture all of the potential profit on every order. There simply continues to be too many transactions to monitor closely. However, there are two significant steps that management can take that should help alleviate the problem.

• Profitability Education—The vast majority of operating employees, as well as much of lower and middle management, has a very poor understanding of how profitability is generated or undermined in the firm. For example, when asked about the impact of one less line on an order, most employees would suggest that the transaction’s profit will fall 5 to 10 percent, not that it will be destroyed. Such differences are critical. No firm wants to turn all of its employees into accountants. However, a more thorough understanding is essential to profit success.

• Better Monitoring Systems—Traditional accounting systems do little to help firms control the issues identified in Exhibit 1. However, new database programs do provide a relatively easy means to make such comparisons. It is essential to begin to track key profit drivers, such as lines per order, by sales-person over time. Without measurement, there is no basis for improvement.

Moving Forward

Most firms experience on-going reductions in profitability without even being aware of it. Such slippages are not limited to the sales area. They occur throughout the business. In order to achieve truly high-profit performance, the typical SEDA member must being to educate its employees on the nature of profit relationships. In addition, it needs to have a tight control system that regularly tracks each of the key profit drivers in the firm.

About the Author

Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2004 Profit Planning Group. SEDA 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.

A Managerial Sidebar on The Losses from Profit Slippages

Many of the factors that erode profits, such as fewer lines per order, are hidden. As a result, they cannot be measured with absolute accuracy. However, some estimates of their impact on the firm can be made based upon a few wide-ranging assumptions.

For the typical SEDA member with $10,000,000 in sales and 25,641 transactions, the impact of not generating a complete transaction would depend upon the frequency with which this event occurs. The following suggests that for most firms it is probably a significant factor and that the lost profit dollars could equal anywhere between 14.1% to 56.4% of current profits.

The impact of price cutting is much the same:

These analyses are based upon one less line per order and a three percent price reduction. Larger reductions in performance would have a much greater impact on the bottom line.