Sales vs. Profit Margin The predominance of the Sales Paradigm Sales/turnover myopia The busy fool Many think as follows: Sales = Income More is better Gross margin Profit Margin = Income Profit Margin is the only income of the business Sales/Turnover Sales are only a way of keeping score Reference: Peter Knight, Hayes Knight Partners Question:How many of you are stuck in the sales paradigm?
The power of the gross margin ExamplePrice decrease = 5% Gross profit decrease = 50% Gross profit goes from $10 $5 Consider effect of price decrease on number of sales Effect on cash
ExamplePrice increase = 5% Gross profit increase = 50% The power of the gross margin Gross profit goes from $10 $15 Consider effect of price increase on number of sales Effect on Cash
Exercise 1: “The Sales Paradigm” In 2000/2001 financial year a Business Unit of Commercial Operations had a turnover of $100M and achieved a profit margin of 2%. What is the dollar value of the profit achieved for the 2000/2001 financial year? ANSWER Profit = Revenue x Profit Margin = $100,000,000 x 0.02 = $2,000,000
Pricing Exercise 1: (Cont) Now let’s explore the effect of pricing on sales. You have been recently appointed to the position of Director - Asset Services (South) and currently you are preparing your budget for 2002/2003 financial year. As Director, you are required to contribute a net profit to the business of $2M. After discussions with the Regional Executive Directors for Southern and South East Region you believe that it would be possible to achieve a profit margin of between 2 – 5%. What level of revenue should you budget if you are able to achieve a profit margin of 2%, 2.5%, 3.0% and 5%?
Pricing So What? What can we do with this information? What impact does this have on the Source of Funds from the RIP? Does more sales mean better? What is the impact of Fixed costs of the business (eg Fixed Labour Costs, Overhead Costs)? Gross margin is the true income to the business
Exercise 2:“The effect of pricing on profit margin” In your notes is the MIS (Management Information System) report for RTCS Statewide. This report highlights a number of key financial indicators. Question: Review the “Winning Margin” financial indicator and determine the cash effect to the business if the actual “Winning Margin” was 2%. The term “Winning Margin” represents the percentage margin between the tendered price that won an open market job and the tendered price that came second. In other words it represents the percentage of money left on the table for an open market job. MIS Report states: Winning Margin: Actual is 5.9%, Budget is 6.3% Work Won:Actual is $45.2M, Budget is 47.7M
ANSWER Cash Effect Money Left on the Table: @ 5.9%=$45.2M x 5.9% =$2.66M (left on the table) @ 2%=$45.2 x 2.0% =$0.9M (left on the table) @ 5.9% - 2%=$45.2M x 3.9% = $1.76M What does this represent in terms of revenue? Revenue Lost=Profit Profit Margin = $1.76M 2.0% =$88M
Pricing Total RoadTek Turnover for 2000/2001 was $280M Lost Revenue of 31% of annual turnover What does that mean? RoadTek could have priced only $192M of work and still achieved the same level profit.
The business cash cycle: Key themes The time, value of money Working capital – preventing bloat in working capital: Debtors Creditors Time How to achieve timely payment using: Invoicing Servicing delivery Reducing disputes Value-adding management Reducing cash cycle times Focusing on tasks Creditor management Creditor strain Settlement discounts Cash Stock equipment Margin Sales Receivables
Cash: Managing cash Positiv e effect on cash Above the line measures Increase gross margin (do not discount) Focus on value added per unit of time or unit of space measures Focus on reducing costs of goods sold to increase price Rationalise product range – drop low margin products Below the line measures Aim to reduce breakeven sales level by reducing overhead costs Balance Sheet Stock Minimise amount and time held Work in progress Focus on job velocity Shorter turnaround Quicker invoicing Debtors Manage debtors Stick to terms and enforce them Recognise your benchmark Creditors Avoid creditor strain Pay in a timely manner
Consider: Sales Terms 30 days net Cash cycle: Controlling cash Sales during the month on credit Customer pays 1 Sept 30 Sept 31 Oct 30 days “30 days”
Calculating benchmarks: Debtors as a % of sales Reference: Peter Knight, Hayes Knight Partners Basis of calculations: No. of days credit given x 100 No. of days in one year Eg. 60 days credit given: 60 X 100 = 16.4% say 16% 365
Calculating benchmarks: Debtors as a % of sales Reference: Peter Knight, Hayes Knight Partners Exercise 3:“Debtors as a % of sales” As at 31 December 2001 the RTCS Business Group reported Accounts Receivables of $25.1M with an estimated annual turnover of $280M. What is the % Sales in Debtors and is this result reasonable? % Sales in Debtors = Accounts Receivables Annual Sales
Calculating benchmarks: Debtors as a % of sales Reference: Peter Knight, Hayes Knight Partners ANSWER % Sales in Debtors = Accounts Receivables Annual Sales =$25.1 $280 =9.0% This represents average days of credit given of 33 days.
Debt Recovery Exercise 3:“Debt Recovery” You have a bad debt of $10,000 and have exhausted all options of recovering the debt and the debt is written off. What amount of additional revenue must be generated to break even and recover this loss. Assume your profit margin is 2%. Reference: Peter Knight, Hayes Knight Partners
Debt Recovery ANSWER Revenue=Profit Profit Margin =$10,000 0.02 =$500,000 Reference: Peter Knight, Hayes Knight Partners
1)Buying/investing in stock “just-in-time” Making a start Check your stock level (raw materials) against the benchmark data Establish where you are now and work on it (use the measure as a guide to progress) Suggestions: Consider free in to store system, i.e. suppliers keep you stocked and charge only what you use Carefully consider bulk buying discounts – calculate the true cost using a discount rate formula e.g. value of stock + interest paid on funds under to purchase and hold for the period (N.B. use your overdraft interest rate) Consider implementing “just-in-time” system with a dedicate supplier for major inputs Shortening the cash cycle Reference: Peter Knight, Hayes Knight Partners
Shortening the cash cycle Reference: Peter Knight, Hayes Knight Partners 2) Focus on job velocity Making a start Identify main products or services Follow each through the various value-adding processes in the business Map out the process and record times taken and delays Measure value-adding time and measure non value-adding time. Establish the value-adding ratio (value-adding time/none value adding time) Use this information to achieve a better result Suggestions Involve staff in key areas in identifying product/service process flows Identify areas of delay and concentrate on the largest first Use measures such as value-adding ratio and time taken, as a guide Consider sub-contracting if you are inefficient in areas
Shortening the cash cycle 3) Invoicing effectively Making a start Balance efficiency with effectiveness, i.e. invoice to get paid as soon as possible (efficiency may dictate invoicing in bulk at month’s end – is this effective?). Recognise the “Gratitude Concept” Suggestions Invoice when tangible value is delivered Plan jobs with invoicing points in mind, based on identifying gratitude points Gratitude Time Job completion/value delivered Invoice here for quick payment Reference: Peter Knight, Hayes Knight Partners
Shortening the cash cycle 4)Receivables and terms of trade Making a start Review your debtors against benchmark Review your terms of trade and performance If performance is below benchmark? Look at: Debtor awareness Invoicing – Timing of invoices Debtor follow-up/terms enforcement Develop a debtors management system Document procedures and train staff Suggestions Review current procedures Develop strict procedures for querying all accounts outside your terms Stick to your terms and enforce where required Review job commencement procedures to ensure terms are explained and given importance Monitor receivables systematically (at least weekly) Reference: Peter Knight, Hayes Knight Partners
Cash cycle: Key principles summarised Bloat or blow out in working capital is caused by: Too much stock Raw materials Finished goods Billable hours Debtors too high Poor creditor management Poor cash management Reference: Peter Knight, Hayes Knight Partners
Cash cycle: Key principles summarised How to shorten the cash cycle: 1.Buy/invest in stock “just-in-time” 2.Focus on job velocity, i.e. shorten the value-adding time 3.Invoice on completion or at key points on the gratitude curve 4.Focus on receivables and terms of trade 5.Always consider the time value of money Reference: Peter Knight, Hayes Knight Partners
Cash cycle: Key principles summarised Depreciation Fixed Assets are Resources Their Earning Capacity Reduces over use and time Depreciation is a measure in the reduction in capacity of the assets No reduction in cash Reduction in asset worth
What Happens to the Wealth Dividends Return to the Owner Reduces Net worth / Equity Reduces Resources (CASH) OR Reinvest No Change to Net Worth No Reduction of Resources are Available to Build the Business