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One of the central tenets of management is that if you want to achieve a goal, you must have a plan. In financial planning, it means that the company must have a clearly defined profit objective in mind.
Unfortunately, most businesses have the identical, ambiguous goal — they want to make more than they do now. Some businesses expand that idea to try to make as much as they can. Such an objective is great as a general philosophy, but it does nothing to help the planning process. In that scenario, the firm is planning with no clear idea of how much profit should be made.
Ultimately, every firm that develops a financial plan constructs a profit objective. However, usually it does so by "residual planning" rather than true profit planning. That is, profit is the residual (or what is left over) after sales, gross margin and expenses have been planned. Profit becomes whatever the calculations say it is.
Ideally, profit should be the first item that is planned every year. With"profit-first planning," the firm can determine exactly what level of sales is needed, how much expense can be incurred and the like. The essential ingredient to begin such an approach is a profit goal.
The primary reason firms don't start with a profit goal is that there are no clear guidelines for what that goal should be. Luckily, hardwood flooring companies have a source to help guide them in this effort — the NWFA Profit Report.
The Profit Report contains detailed information on actual profit levels, as well as other key financial results, for both the typical NWFA member and the most profitable members. By using the Profit Report, firms can begin the planning process with a precise, attainable profit goal in mind.
This article uses the profit survey to help those in the industry begin to take a profit-first approach to planning. It does so by examining two key issues:
1. Setting a Profit Goal: Using information directly from the Profit Report to develop a realistic target.
2. Time-Phased Planning:Identifying an improvement plan that moves toward higher profits as quickly as possible.
Setting a Profit Goal
Probably the best overall measure of profit performance is return on assets. Return on assets (ROA) is simply profit before taxes expressed as a percentage of total assets. Total assets is the total investment in the business—all of the cash, accounts receivable, inventory and fixed assets.  The value of ROA is that it measures the economic viability of the business. If the ROA is not sufficient, the firm is better off investing in some other business.
In determining how much profit, or more specifically, how high a ROA, is required to maintain the viability of the firm, there are two different approaches that can be employed:
- An absolute requirement
- An industry-specific requirement.
The absolute requirement emphasizes that every firm in every industry must produce an adequate profit. There are no exceptions. The industry-specific approach reflects the fact that every industry is different, and profit potential is influenced at least in part by specific industry economic and competitive conditions.
The absolute requirement approach suggests that return on assets must cover the risk associated with the investment in assets, must offset the inflation that eats at the asset base each year and must provide some return to expand the asset base. Analysts differ as to what the minimum absolute return should be, but most estimates range between 8 and 10 percent.
The industry-specific approach accepts the inevitability that profit varies by industry. With this view,profit goals should be based on actual industry performance. It is an empirically-based approach to planning. This is where the NWFA Profit Report proves so valuable.
What does the report say. It suggests that like most industries, NWFA is somewhat two-tiered in terms of profitability. That is, there is a median level of return on assets that is achieved by the typical firm. At the same time, there is a high profit level that reflects the performance of the top firms. The gap between the two numbers is almost always substantial.
Figure 1 illustrates the size of the gap for NWFA members. It looks at two firms of identical size. For the typical NWFA company, dollar profit and ROA are somewhat unexciting. However, for the high-profit business, the results are much more interesting.
Figure 1 also demonstrates thatthere is not just a difference in therate of return. The absolute dollarsproduced on the same amount ofsales—and with the same amount ofeffort—is dramatically different.
It should be noted that the high profit results are not for the elite companies. Instead, they represent the results of the top 25 percent of the businesses. If one-fourth of the firms operating in the same industry can produce a superior ROA, then every business in the industry should be able to produce it.
Given the profit gap, which persists every year, a reasonable initial goal is for companies to move toward the high-profit figure. The only real challenge is how quickly firms can reach the high-profit goal.
Time-Phased Planning
The prevailing mindset among most managers is that large and rapid increases in profitability are possible. This is simply part of the entrepreneurial spirit that suggests that businesses should move ahead quickly.
The expectation of exceptionally rapid profit improvement blissfully ignores the magnitude of the hurdles that must be overcome to reach high profit. Many times the result is a profit goal that simply cannot be met. If this process is repeated, eventually a brutal cycle of continually missing targets develops. Ambitious profit goals are replaced by discouraging reality.
A much more realistic approach is to move incrementally towards higher profits. Ideally, this involves becoming a high-profit firm in a period of three to five years. The bottom part of Figure 1 reflects how much of an improvement in ROA a typical firm would require each year to reach high-profit status in either a three year or five-year period. The answer is simply the difference between the goal figure and the current figure divided by either three or five.
Once an appropriate time frame has been established, the firm can use a specific planning methodology to target profit. This methodology is outlined in Figure 2.
Figure 2 is extremely simple, involving only six steps. It is so simple, in fact, that many managers conclude incorrectly that the process isn't complex enough. The reality, however, is that the approach identified in Figure2 has the proven ability to dramatically change company performance.
Figure 2 has two columns of numbers and a blank column. Both of the columns with numbers present an improvement plan for the typical NWFA member. The blank column is for your firm's use in the planning process. The first column of numbers uses a three-year time frame for reaching high-profit results. The second column uses a five-year time frame. They both represent sound alternatives and are attainable by every firm. The only challenge is to actually work through the process line by line.
Line 1: Enter pre-tax profits for the last completed fiscal year. If the planning process starts before the year is completed, then estimates are fine. (In the two columns that are filled in, the numbers are for the typical NWFA firm that was introduced in Figure 1.)
Line 2: Enter end-of-year assets. Again, estimates are acceptable.
Line 3: Calculate return on assets by taking line 1 and dividing by line 2.
Line 4: Estimate a one-year change. This is where the two columns provide very different answers. Both goals come directly from the bottom of Figure 1. In the three-year plan, the business is increasing ROA at a much more rapid rate. In both cases, however, the business is still moving forward systematically.
Line 5: Add the figures from Step 3and Step 4 to determine a target return on assets. This is where the business legitimately should try to be in one year.
Line 6: Determine the year-one profit goal. Simply take the assets number in line 2 and multiply times the target ROA. The answer is how much profit the business should target for next year. It is significantly more than was made this year. However, it still represents a realistic profit goal.
Simply setting a profit target is no guarantee of success. It is, however, better than having no goal at all. The firm knows where it needs to go and how fast it can get there.
Moving forward
The business cannot just set a profit goal and stop. It must develop a complete financial plan. Again, the NWFA Profit Report is a valuable source of information on factors such as sales per employee, gross margin percentages, inventory turnover and the like. It is a tool that should be in the arsenal of every NWFA member. Before the plan can be completed,however, it has to be started. That process must start with a profit-first view of planning.