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It appears we have stumbled into a recession. Since the worst of the economy's problems are occurring in the housing market, many hardwood flooring contractors have been hit hard. However, whether this creates a profit crisis or simply a profit problem for contractors depends in large part on how they react to the downturn. A recession impacts sales at various levels, and many owners take actions that actually cause more harm than good to their businesses. But there are some actions you can take to come through a recession unscathed.
The Impact of a Recession
The actual impact of a recession on sales is almost always exaggerated. While there are always a few businesses for which sales fall dramatically, most only experience a loss of between 5 to 10 percent. The problem is that most businesses aren't flexible enough to adjust to a sales decline. Consequently, a small decline is enough to wipe out a significant portion of a company's profits.
The table in "Comparing Cutbacks" on page 40 looks at a typical NWFA dealer/contractor-member business. According to the most recent Dealer/Contractor Profit report, this company has $1,500,000 in sales volume, a gross margin of 40 percent of sales and a pre-tax profit of $45,000, or 3 percent of sales. It may seem that 3 percent is somewhat insignificant, but even small changes in sales or margin could lower profits dramatically.
In order to fully understand how changes in sales impact profits, it is necessary to break your expenses down into either fixed or variable. Fixed expenses are expenses the business has an obligation to pay regardless of sales volume. In contrast, variable expenses are those that result from sales.
Commissions are the classic variable expense. For most companies, fixed expenses are by far the largest component of total expenses. For the typical company in the table on page 40, $450,000 of the expenses are fixed. In contrast, variable expenses are assumed to be 7 percent of sales, or $105,000.
The second column of numbers shows the impact of a 10 percent sales decline. Because of the inability of the business to shed any of its fixed expenses, profit falls from the current $45,000 to a loss of $4,500, a decline of 110 percent.
Hurting or Helping?
There are a number of actions companies can take to try to counter the sales decline associated with a recession, but some may be misguided. They usually make a somewhat bad situation terrible. Two of the worst courses are:
Price Reductions. When sales fall, you may instinctively cut prices in order to increase sales. It is difficult, if not impossible, to argue with the logic of "some sales volume is better than none at all." At the same time, you should be fully aware of the negative impact that price reductions have on profits. The last column of numbers in the table displays the company's results if it reduced its prices by 5 percent in an attempt to drive additional sales. In most cases, this doesn't really produce additional sales; it simply results in the sales that would have been generated anyway, but at a lower gross margin.
The price reduction doesn't just lower profits further, it decimates them. Instead of reducing profit to a loss of $4,500, the company ends the year with a loss of $67,275.
Reducing Marketing Efforts. A second common reaction to a recession is for a company to cut its marketing. The logic is that if people are not buying, there is no use promoting your company to them. This undoubtedly has a positive impact in the short run. Cutting any cost that was always present will automatically make your profits look better. However, failing to promote your business tends to cause sales to remain sluggish well after the recession has ended. The business is put into a position of having to catch up with regard to visibility. Only when demand again becomes universally strong and all businesses benefit do companies that nixed their marketing begin to enjoy the sales increases that those with greater name awareness have already experienced.
The two areas where your business should take steps to counter the downturn are discretionary expenses and sales effectiveness.
Discretionary Expenses. During good times, every company gets looser on cost control than it should. This is nothing more than human nature. During the downturn, modestly trimming a long list of small expense items can reduce total expenses enough to offset part of the sales decline.
Sales Effectiveness. This is another topic that should be—but typically isn't—addressed when times are good. Most companies have both great salespeople and terrible ones. In good economic times, poor salespeople hold back profits somewhat. In bad times, poor salespeople are a threat to the company's viability. It may seem brutal, but they need to improve or move on.
Moving Forward
Nothing is going to make an economic recession pleasant. However, companies need to understand the size of the sales volume decline they can weather without panic. They also need to take actions that make things better rather than worse.