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By Albert D. Bates

Most distributors are experiencing strong sales gains. The serious concerns about generating adequate sales are largely a thing of the past. Unfortunately, the strong increases in sales are not translating into strong increases in profit. Expenses — especially payroll expenses — are absorbing an excessive amount of the increase in sales.

The key to overcoming this problem (and generating substantially higher profits) is to produce a “sales-to-payroll wedge.” Simply put, sales must grow faster than payroll expense. It is simple to understand, but difficult to implement. 

Let’s examine the nature of the sales-to-payroll wedge from two perspectives:

⦁ The economics of a sales-to-payroll wedge: how sales growth and payroll   control combine to produce higher profits.
⦁ Implementing the wedge: specific management actions required to generate a   sales-to-payroll wedge.

The Economics of a Sales-to-Payroll Wedge
One of the oldest management bromides in distribution is, “Sales are vanity, profits are sanity.” Bromide or not, the statement continues to be true. Sales growth almost always helps, but what is needed is sales growth that does not require a commensurate increase in payroll expenses.

Figure 1. The Impact of a 2% Sales-to-Payroll Wedge for a Typical PEI Member
    2.0 % Sales-to-Payroll Wedge
Income Statement ($) Current Results 5.0% Sales Growth 15.0% Sales Growth
Net Sales $7,000,000 $7,350,000 $8,050,000
Cost of Goods Sold 4,970,000 5,218,500 5,715,500
Gross Margin 2,030,000 2,131,500 2,334,500
Payroll and Fringe Benefits 1,225,000 1,261,750 1,384,250
All Other Expenses 665,000 698,250 764,750
Total Expenses 1,890,000 1,960,000 2,149,000
Profit Before Taxes $140,000 $171,500 $185,500
Income Statement (%)      
Net Sales 100.0 100.0 100.0
Cost of Goods Sold 71.0 71.0 71.0
Gross Margin 29.0 29.0 29.0
Payroll and Fringe Benefits 17.5 17.2 17.2
All Other Expenses 9.5 9.5 9.5
Total Expenses 27.0 26.7 26.7
Profit Before Taxes 2.0 2.3 2.3

Figure 1 shows the economics of sales and payroll growth. It reflects the results for a typical PEI member based on the latest “Distributor Profitability Report” (DPR) published for PEI by the Profit Planning Group. The Current Results column indicates that the typical firm generates $7 million in sales and operates on a gross margin of 29 percent of sales. It produces a pretax profit of 2 percent of sales, or $140,000. Total expenses are weighted heavily toward payroll, which represents 17.5 percent of sales, or 64.8 percent of total expenses. This is why payroll control is critical.

The last two columns examine the impact of a sales-to-payroll wedge. Again, this means that sales growth outpaces payroll growth. Two sales growth scenarios are used to examine the sales-to-payroll wedge: 5 percent and 15 percent.

Slow growth. The 5 Percent Sales Growth column reflects operations in a mature market. This growth rate was achieved with no change in the gross margin percentage. As a result, cost of goods sold and gross margin also increase by 5 percent.

The key to this column is that payroll expense increases only by 3 percent. This provides a 2 percent sales-to-payroll wedge (5 percent sales growth minus 3 percent payroll growth). For most firms, 2 percent is a realistic goal that should be part of planning.

The other expenses (all of the nonpayroll items, such as rent, utilities, interest and the like) are assumed to increase at the same rate as sales. Realistically, such expenses would not grow as fast as sales; however, this assumption allows the figure to focus exclusively on the power of the sales-to-payroll wedge.

The modest 5 percent sales growth does wonders for the bottom line if the 2 percent sales-to-payroll wedge can be generated. Profit increases from $140,000 to $171,500; an increase of 22.5 percent. Profit is now 2.3 percent of sales.

Fast growth. The last column examines the impact of more rapid growth, defined here as a 15 percent sales increase. The same sorts of effects that were observed in the 5 percent column also are seen here. The gross margin percentage stays at 29 percent, so sales, cost of goods and gross margin all increase by 15 percent.

A 2 percent sales-to-payroll wedge remains the goal, so payroll increases only by 13 percent. The other expenses follow the same growth path as sales and increase by 15 percent. The result is that profit grows by 32.5 percent to $185,500.

A more rapid rate of sales growth produces a somewhat larger bottom line; however, to get to $185,500 in profit vs. the $171,500, the firm had to generate another $700,000 in sales. It probably had to hire more employees; payroll increased to $1.38 million. It was a lot more work.

Rapid sales growth makes the sales-to-payroll wedge a little easier to produce. Sales growth, however, is not behind higher profits. What matters is how much sales can be increased in relationship to how much payroll has to increase to support that sales growth.

Implementing the Wedge
At this point, producing a sales-to-payroll wedge should seem like a great idea. Readers may quibble with the 2 percent figure if they desire, but a wedge of some size seems essential. The issue is to identify how such a wedge can be generated.

In trying to produce the sales-to-payroll wedge, remember that improved productivity systems probably are not the answer. Distributors have become much more sophisticated in using technology tools during the past decade, yet payroll remains about the same percent of sales as 10 years ago. There has been no sales-to-payroll wedge.

Something else is required that necessitates attention to the three areas where the sales vs. payroll expense trade-off should be positive.

Lines per order. Putting more lines on every order allows for a sales increase with only a modest payroll cost increase. Increasing the lines per order revolves around two actions.

The first is to have the sales force do more add-on selling, an issue of monitoring, evaluating and compensating.

The second action in driving more lines per order is to ensure customers are aware of everything in the firm's assortment. There’s nothing wrong with telling customers over and over about one-stop shopping.

Fill rate. If you don't have it, you can’t sell it. And if you don't have it often enough, all of your customers go away. Improving the fill rate, however, leads to the requirement of carrying more inventory.

Adding inventory to increase sales is always a good idea, but adding inventory without increasing sales is a terrible idea. Too many firms have cut inventory to the point that sales are affected negatively.

Average line value. Increasing the average line value, or line extension, is largely a pricing issue. No customer wants to pay too much. Every distributor, however, has a large array of slower-selling items for which availability is much more critical than price. It is an opportunity that needs to be exploited to produce more sales dollars from the same unit sales.

With the effort to increase the fill rate mentioned, the opportunity to be the “always in stock at a fair price” distributor increases substantially. The increased fill rate, though, must be supported by fair-value pricing. Firms must get paid for the services they provide.

Moving Forward
Payroll as a percent of sales is stuck in a rut that goes back at least 10 years. If firms are going to lower their payroll expense percentages and increase their bottom lines, they must plan with the sales-to-payroll wedge in mind. Generating that wedge will require emphasizing three concepts: more lines per order, a higher fill rate and an increase in the average order line value.

Albert D. Bates, Ph.D., is founder and president of Profit Planning Group. He is the author of the newly released “Breaking Down the Profit Barriers in Distribution” available through Amazon and Barnes & Noble.