Watching Your Profits Slip Away

Despite the advances at the top of the organization, decisions continue to be made at the bottom that systematically erode profits.

By Albert D. Bates, Ph.D.

GAWDA 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 GAWDA 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.

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

The thought of simply processing 44,444 orders and 133,333 order lines is daunting enough. The thought of doing so with 100 percent 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 GAWDA member. The numbers reflect the results identified in Exhibit 1. 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 3.8% of sales.

As can be seen at the bottom of the first column, the typical transaction produces a meager profit of only $7.20, which represents the profit margin for the typical GAWDA member of 4.0% 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 $15.36 on the entire order.

The final column examines what happens when a 3.0% 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 smaller, with a profit of only $2.55.

Both of these are real-world situations. With diligence, it is 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 continue to be too many transactions to monitor closely. However, there are two significant steps that management can take that should help alleviate the problem:

1. 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.

2. 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 salesperson over time. Without measurement, there is no basis for improvement.

Moving Forward
Most firms experience ongoing 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 GAWDA member must begin 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.