It’s the worst. It takes the wind out of your “we-had-a-great-sales-month!” sails. And almost everyone has experienced it. Your sales grew, but you were less profitable (as a percent of sales). Why did that happen? Well, in all likelihood, the problem is “above the line”, which means above the gross profit line. Look carefully at your sales and cost of goods sold; those lines on the P&L represent the two most impactful organizations in your business: sales and operations. Most financial problems in the business can be traced there. The following are my top five reasons (all found “above the line”) why sales can be up while profitability is down.
1. Sales Mix
A timeless lesson: if gross profit/margin fluctuates across periods, it’s often due to a change in “mix” of what was sold – particularly when it comes to businesses with multiple kinds of inventory. Said another way, a different combination of products (or services) sold results in a different gross profit. Seems pretty intuitive, but you can save yourself hours of mind-numbing analysis elsewhere if you start your analysis with that fundamental tenet. If sales mix did indeed change, it follows that your next question is, “Why?” Reasons could span from an unpredictable (or predictable) change in customer needs/preferences, to being out of stock in one or more items, to running a sale on certain items that resulted in increased volume at a discounted price.
As noted above, pricing could directly impact sales mix in a given time period (i.e. you ran a “special”), or it could be a longer-term issue. In a B2B environment, make sure your sales force is disciplined when it comes to maintaining customer pricing and being transparent in their reporting of sales activity. All too often, pricing is the first thing on the negotiation table with customer interactions. Whether it’s B2B or B2C sales, once you’ve lowered prices, it’s a herculean effort to raise them again and not lose business. Commoditized products or services are particularly difficult when it comes to maintaining pricing, which makes it even more important that you find other ways to provide (and identify) value for your customers. Your best bet? – be in a business where prices are expected to go up over time, and be in the habit of taking annual price increases!
3. Labor Hours
Labor hours can sneak up on you in a heartbeat. Let’s face it, employees are smart and will almost always look for opportunities to take advantage of overtime hours and the resulting wages at “time and a half”, or worse, “double time”. Manage your overtime hours, and in turn your headcount, carefully. At a minimum, ensure that customer pricing supports the overtime incurred. Ideally, hire the incremental labor required at straight-time wages to support the sales growth.
Because it’s so important, I’m going to squeeze in a note on managing labor in the construction/contracting industries, especially when you know that sales are actually down: manage your labor downtime, or idle time, with careful scrutiny. Employees will show up to a job site on a bad-weather day and will expect to be compensated for their hour or two before going home. Ensure weather calls go out early. And, eliminate “shop time” – that is, crews coming in-house for the day to “lend a hand” because of weather or other delays on the job site.
Finally, whether in a sales growth or retraction period, take permanent steps to measure and reward efficiency – i.e. rewards crews, departments, or shifts for getting the job done with the same quality, but faster.
4. Rental Equipment
Rental equipment, like labor costs, can creep up over time and erode profitability. Supervisors whose compensation is not, at least in part, aligned with financial performance are inclined to rent what they need without much thought – they simply want to get the job done. Then, rental equipment builds and results in excessive idle time sitting in the yard. So, when it comes to rental equipment, ask yourself these questions:
1) Do I really need it?
2) Do we already have it somewhere else in the company and need to shift things around?
3) Am I renting the sports car model, or a reliable, used model that gets the job done?
4) How often, and for how long, is rental equipment sitting idle?
5) Have I done a “lease vs. buy” analysis and where is the best ROI?
6) Have we developed, as a core competency, the skill/process to consistently identify and acquire quality used equipment that is most heavily utilized in our business, and do we have the financing to support those acquisitions?
7) Can I give it back, or end the lease, quickly if I need to?
Just as you will want to increase your customer pricing over time, so will your vendors want to raise their prices on your inventory and your costs will rise. Here are the relevant questions to ask when doing cost analysis of your inventory:
1) Are you analyzing inventory turnover and segmenting inventory into A-B-C categories? (i.e. A is the highest volume mover, then B, etc.)
2) Within the segmentation noted above, what is your inventory cost for a given item doing over time? How often is it going up? Do you need to promote higher-margin B items over lower-margin A items?
3) Who are you buying inventory from and why? Can you get the same product quality cheaper, but just as timely, by going elsewhere?
4) Are shipping/delivery terms favorable to you? Are they negotiable?
5) Can you take volume discounts? If so, do you have the working capital financing and storage capacity in place to accommodate larger purchases?
6) Do vendors offer “early-pay” discounts and are you taking them? If not, why? Note, for many lower-middle market companies, this a “cash flow vs. profit margin” question where short-term cash flow needs usually win and early-pay discounts are forfeited. Ideally, you will have the liquidity to take advantage of early-pay discounts.
There are certainly other reasons for profitability decline when sales are growing, including over-hiring to match the increase in sales volume, and under-estimating costs when bidding jobs – both of which are gross profit, or above-the-line, issues. Depending on the industry, these should both be high on the priority list for scrutinizing. Furthermore, are you allowing G&A expenses to run amok? G&A expenses are “below the line” and typically fall under the purview of the CFO. A good CFO will always prioritize decreasing G&A expenses as a percentage of sales to the extent possible.
In conclusion, there are a number of considerations and analyses to perform when you find sales are growing but profitability is down. I’ve provided a short list that crosses industry boundaries and reflects my past experiences. You’ll obviously need to customize your list to fit your specific business. As a general rule though, no matter the industry, if you start with a thorough analysis of your sales and cost of goods sold, you will find most of the time that therein lies the issue(s) for declining profitability when sales are growing.