Log in to view the full article
As the economy shows signs of righting itself, most managers already are breathing a sigh of relief. They believe the unpleasant expense cutting associated with the recession soon can be forgotten.
Sales seem destined to recover, and sales growth, as the old adage goes, solves a lot of problems.
Unfortunately, such a view ignores the factors that drive profitability improvement at the beginning of economic recovery. It is continued expense control, not sales growth, that is the profit-driver during the early portion of recovery.
Managers need to understand why this is true and which actions to take. Looking at three main issues can clarify a plan for the future. These issues are:
- The impact of expense problems: How debilitating even modest expense problems can be
- Goal setting for expense management: Establishing specific expense goals
- Expense control techniques: Some actions that can make expense control a long-term reality.
The Impact of the Expense Challenge
The factors that drive profitability over time arelargely cyclical in nature. What works at various stages of the business cycle is highly predictable based upon the past. During a down cycle, expense cutting is rampant; however, after recovery is firmly established, it is sales growth that drives profit improvement. If the economy continues strongly, the emphasis inevitably switches to gross margin as companies try to maximize what becomes almost automatic sales growth. The challenge in the initial stages of economic recovery is that the solemnity of expense control too quickly gives way to the euphoria of sales growth. The result is that sales are vibrant, but profits are not.
The problem, however, is not that expenses are out of control. Instead, the issue is that the emphasis on sales naturally causes expense planning to take a back seat in the minds of most managers. The far-too-common result is that sales grow, but expenses grow even faster.
Figure 1 demonstrates the nature of the expense challenge for a typical NWFA distributor member. Based on the latest profitability survey, such a member has three important characteristics:
- net sales of $14,000,000 per year
- a gross margin percentage on those sales of 19.8 percent
- a pre-tax profit margin (profit as a percent of sales) of 1.6 percent
This example illustrates the impact of "expense creep"—where sales grow but expenses grow slightly faster—on profit margin. The figure depicts the results of expense creep rates of one, two and three percentage points. That is, expenses are growing 1, 2 or even 3 percent faster than sales.
The results for 2001 reflect a current profit margin for the typical NWFA member of 1.6 percent. The figure demonstrates that a 1 percent expense creep factor causes profit margin to decline modestly. A 2 percent factor reduces profits at a relatively rapid pace, and a 3 percent factor decimates profits very quickly.
Once again, even if sales are rising, profitability is diminished as long as expenses are rising faster than sales.
This is what frequently happens at the tail end of a recession. It is a situation that can be avoided through continued expense management.
Setting a Sales Productivity Goal
It is essential to think of expenses in relation to sales growth. Figure 2 reflects the performance of the same typical NWFA member in a recovery mode where sales are growing at a rate of 3 percent. The sales are compared against three very different pro forma levels of expense increase:
• Level 1: Very loose expense control—expenses increase by 4 percent to produce a 1 percent expense creep factor
• Level 2: Sales and expense parity—expenses increase at the same 3 percentrate as sales
• Level 3: Tight expense control—expenses are tightly controlled and grow by only 2 percent.
Several points are worth noting in Figure 2. Most obvious are the wide profit swings between the three different scenarios, even though all three are experiencing the same level of sales growth. Coming out of a recession, increasing sales solves a number of problems, but not all of them.
The first scenario—where sales are growing by 3 percent while expenses are increasing by four percent—is of primary importance. It demonstrates that the potential to drive more sales while generating fewer profits is a major challenge during the slow growth period of initial economic recovery.
The second key point is that allowing expenses to rise at the same rate as sales is not good enough. In the middle of the three pro forma columns the company experiences a 3 percent increase in both sales and expenses. The result is profit also increases by only 3 percent. The bottom-line profit margin for the firm remains 1.6 percent. Parity in sales and expense growth merely keeps the business treading water.
Finally, it is interesting that the reward potential from expense control is demonstrably larger than the penalty from expense creep. In the final column, the percentage increase in profits that arises with tightly controlled expenses is substantially larger than the decline if expenses are not controlled. The period of slow initial economic recovery can be a time of substantial profit improvement if the expense control mentality of the downturn is maintained.
In short, managers must not become so enamored with the relief of newfound sales that they lose sight of the expense philosophy developed during economic gloom. The switch from focusing on expense to focusing on sales is much more gradual than is often thought to be the case.
Expense Control Procedures
Maintaining an expense focus is not easy. To ensure that expenses do not get lost in the sales shuffle, managers should incorporate three specificactions in their planning:
• Companies should revive the concept of "zero-based budgeting."
To the extent that anybody even remembers zero-based budgeting, it usually is thought of as a discredited relic from the Jimmy Carter era. The perception is that because the concept didn't work to stop the growth of the federal government, it will not control expenses in the private sector.
In reality, zero-based budgeting is ideal for this phase in the business cycle. Every expense category must bebuilt from the ground up by justifying why each dollar is spent. If an expense cannot be justified, it is a candidate for elimination. This approach allows firms to kick the COLA (Cost of Living Adjustment) habit of automatic increases in expenses each year. It is time to stop doing things because "we always have done them."
• Management should at least pay homage to Jack Welch.
Since his retirement from General Electric, Welch has gained the mos tnotoriety for that part of his book, Jack: Straight from the Gut, in which he expresses the conviction that every year the firm should fire the lowest performing 20 percent of the employees. Such a mindset is viable in a 100,000 employee company; however, it realistically is too Draconian for small to mid-range companies.
However, the essence of what Welch says is true. The company that continues to carry non-performing employees simply because they always have worked there is paying a heavy expense penalty. It should be remembered that, for the typical NWFA member, payroll and fringe benefits represent 63.7 percent of total expenses. Productivity cannot be sacrificed.
• Companies should fire the bottom 2 percent of their customers and rehabilitate another 10 percent.
Most businesses have a relatively large number of customers who produce little profit. They also have a small number of customers who are absolutely unprofitable. In a time of recession, nobody wants to lose a customer. As economic recovery emerges, it is a great time to sacrifice unprofitable accounts and concurrently lower the expenses associated with servicing those accounts. Firing the terrible customers is the easy part. Working with the problem accounts is more difficult. The positive impact from an expense perspective can be staggering, though.
Moving forward
Although the beginnings of recovery seem close at hand, the recession may or may not be over. Now is not the time to forego the reforms that were implemented during the bad times. Instead, companies should build on those improvements with continued expense control—at least during the first year or so of recovery. Doing so will help keep businesses fine-tuned and capable of handling whatever lies ahead.