The first in the “Profit Secrets of The 10% EBITDA Club” series of articles covers a relatively simple concept to enhance profits that way too many electrical distributors overlook.
Few wholesale distributors have entered the rarified air of 10% EBITDA (earnings before interest, taxes, depreciation and amortization). It's super- elite territory, and less than 1% of distributors make it there.
We've talked to such distributors, and actually worked for one. We know what they do in all facets of their business. We also know top management needs to absorb and drive performance in all areas to reach 10% EBITDA. You can't just be good at sales, marketing, operations or asset management — you need to excel on all fronts because they work together like an offensive line, quarterback and receivers. Fail to excel with any of these and you won't even come close to 10% EBITDA.
We need to tell you one very important thing about EBITDA. It's not the end-all, be-all measure. That measure is return on investment. Grocery stores can operate really well at 1.5% because they turn their assets faster. You can't. Still, operating margins need to be maximized relative to investment required, so we're going to focus there. In this article, we're going to start with the most important “secret” of them all. It's the starting place if you're going to get it about any of the others. First let's look at what it is not.
The #1 key to profitability is not gross margin percent. Heresy, you say. Everyone says gross margin percent (GP%) is the #1 key to profitability. It helps, but sometimes it can actually hurt. Thinking that high GP% is the #1 key to profitability will keep you from focusing on the thing you can change to make a real difference in your net profitability — gross profit dollars per order relative to transaction costs per order.
Why is that? Consider that transaction costs per order are relatively fixed for each type of order, such as stock orders, nonstock direct ship orders, nonstock locally sourced orders, project direct ships, will-calls, or counter serviced orders. Your job is to exceed the fixed transaction costs on each order and that depends on a number of things. Here are the six determinants of Gross Profit per Order:
Gross Margin Percent (the right price)
Accurate product cost data (the right cost)
Number of line items
Price of each line item and GP$ per item
Quantities per line item
Claiming and collecting SPAs due in the right amounts
We boldfaced “Number of line items” because that's where you have the most leverage to change behavior of both your people and customers. We'll talk about the others in the next few articles. The other things on the list are mostly good mathematical and system disciplines, so everybody can do them if they so choose. And there's really no excuse for not doing them.
Changing customer buying behavior through good marketing and sales techniques is the essence of good marketing and sales. That's the #1 thing that separates the 10% EBITDA club from the rest. That will improve company profits, the morale of your staff and the amount of bonus money you take home to fund a better life for yourselves and your families. Keep in mind that gross profit quality and quantity per order is one half of the equation. The other half is getting your transaction costs down through sound operations management. In this series, we're going to focus on the marketing and sales side that creates high gross profit per order. Here's how to get a high number of line items per order:
Drive outside sales to get end user and contractor customers to agree to purchase a broad mix of product lines.
Get inside sales and counter sales to recommend tie-in sale items on every order.
Customize your marketing mix to each customer with direct marketing techniques. That means identifying what each customer is not buying but should be buying, sending the right product messages to each customer to broaden the mix, and coordinating marketing promotions with sales efforts.
Not quite that interested yet? Perhaps if we showed you how much more money you could make, you would get excited about the potential. Broadening the product mix at each account can drive profits skyward. Suppose you are a distributor with annual revenues of $40 million, operating costs of 18%, gross profit of 21% and 100,000 orders per year. You sell from stock only and deliver all orders. Your simplified operating statement will look like Chart 1 on page 21.
But let's look deeper and make some assumptions. On the average, you need to make more than $72 per order in gross profit to make money on a transaction. A customer needs to average more than $72 of gross profit on their orders to make money for the company. The best way to do this is to improve the mix of products bought at each account and on each transaction.
In reality, you have a different cost structure for each type of order. Direct ship orders cost less if you don't have to pay freight and you don't have to spend much time engineering or expediting the order. Counter orders are picked up so you avoid delivery costs. But counter orders have other costs that offset some of the costs of delivery, like floor space and merchandising costs. Web and EDI orders have practically zero order-entry costs. They are replaced by a fixed technology cost that gets lower per order as orders increase.
If you're not impressed, let's look at the impact of selling one more line item per order with a success rate of 20%, as a result of converting accounts to your brands more often and tie-in selling through inside sales and counter sales more often. That would add 0.2 line items per order. Assume your only operating cost increase comes with sales commission and incentives of 15% of gross profit, which accounts for the increase in operating costs of $84,000. Check out the results in Chart #2: A New & Improved Order Mix (page 21). You raised your net profits by more than a third from $1.2 million to $1.67 million. You raised your net profit percent of sales from 3% to 3.9%.
Why does this work? It's a rather simple concept. You spend money to do things with customers. When you get more money coming in to cover the relatively fixed expenses, the rate of profit skyrockets. So, you need to leverage every customer and every order for all product line opportunities, period. Sound like a plan? Not quite yet. Next month we'll talk about strategies and tactics to create a solid gross profit per order improvement plan.
Neil Gillespie is a veteran distribution consultant, speaker and author. He helped Roden Electrical Supply, Knoxville, Tenn., grow more than 500% over 11 years while more than tripling EBITDA percentage. Gillespie has distilled his profitable growth methods in his “Eight Steps to Breakthrough Growth.” His book Discover Your Core, Then Go for More, is available on iBooks and Amazon.com. Contact him at firstname.lastname@example.org
Allen Ray is a veteran distribution owner, author, speaker and industry consultant for the electrical, plumbing, HVAC channels. His expert advice is drawn from a professional distributor knowledge base across many vertical channels. Ray can be reached at email@example.com.
CHART #1: BEFORE THE CHANGE
|Gross Profit||$8,400 (21%)|
|Cost of Goods Sold||$31,600|
|Operating Costs||$7,200 (18%)|
|Net Profit Before Taxes||$1,200|
|Net Profit % of Sales||3.00%|
|Number of Orders||100,000|
|Total Cost Per Order||$72|
|Average GP$ Per Order||$84|
|Average Revenue Per Order||$400|
CHART #2: A NEW & IMPROVED ORDER MIX
|Operating Measure||Before||Better Mix|
|Cost of Goods Sold||$31,600||$33,707|
|Net Profit Before Taxes||$1,200||$1,676|
|Net Profit % of Sales||3%||3.9%|
|Number of Orders||100,000||100,000|
|Total Cost Per Order||$72.00||$72.84|
|Average Gross Profit Per Order||$84.00||$89.60|
|Average Before Tax Profit per Order||$12||$16.76|
|Average Order Size||$400.00||$426.67|
|Line Items sold||300,000||320,000|
|Average GP$ per line item||$28.00||$28.00|
|Line Items per order||3||3.2|
|Revenue Per Line Item||$133.33||$133.33|