Measuring Performance Silver and Gold

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You makehow

muchprofit?

Greed is Good saidGordon Gekko, but what isa fair profit? Indeed, whatis profit? Paul Rogersshines his torch into themurky world of profit.

It may seem premature toexplore profitability, whenmany buyers have beenmore concerned with thesolvency of their suppliersthan their profitability. Butthe start of a new financialyear is often the prompt formanagers to apply revisedstrategies - including

pricing - to their accounts,based on a review ofperformance, includingprofitability. Because asevery supplier will tell you,without profit there is nobusiness.

Gross or Net?How much profit do youmake? This question isalmost not worth asking,as interpreting the answerdepends upon whatdefinition of profit is beingassumed. [I should alsoadd that most companieswould love to know theanswer to this question

themselves, as theunderstanding ofprofitability is as much anart as it is a science!]There are three commonlyused definitions ofprofitability, and buyersshould have a workingunderstanding of each ofthem.

Gross Profit is thesimplest concept, and agross profit margin issimply total sales less thecost of goods sold. It isusually expressed as aratio of total sales. Forexample, if a company has

$1 million in sales and thecost of its labour andmaterials amounts to$600,000, the grossmargin would be 40% [i.e.($1m-$0.6m)/$1 million].This is the broadestmeasure of profitability, asgross profit is calculatedbefore subtracting non-production expenses, suchas the costs of sales and

administration, taxes, and

depreciation. It indicateshow efficientlymanagement uses labourand supplies in theproduction process.

However, gross profit isnot cash in the bank thatthe business can spend ondividends to shareholdersor new BMWs for all the

category managers! Wehave to deduct from grossprofit all the otherassociated costs withrunning the business, suchas insurance, advertisingand overheads.

Net Profit is profitgenerated from all phasesof a business, includingtaxes. This ratio comparesnet income with sales, and

However, gross

profit is notcash in thebank that thebusiness canspend ondividends toshareholders or

new BMWs forall the categorymanagers!

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is a proxy measure for how

effectively managers runthe business. If acompany generates after-tax earnings of $100,000on its $1 million of sales,then its net marginamounts to 10%. In thiscase, 30% of the grossprofit is taken up by rent,taxes, advertising etc.

If we really want tounderstand the underlying

profitability of a business, itcan be helpful todistinguish between theoperating profitand netprofit. By comparingearnings before interestand taxes [EBIT] to sales,operating profit marginsshow how successful acompany's managementhas been at generating

income from the operationof the business. If EBIT

amounted to $200,000 and

sales equalled $1 million,the operating profit marginwould be 20%. This ratiois a rough measure of theoperating leverage acompany can achieve inthe conduct of theoperations of its business.

So what?Buyers are typicallyinterested in profitability forthree reasons;1. When financiallyappraising potentialsuppliers.1. When negotiatingcommercial terms withexisting suppliers.2. When consideringawarding additionalbusiness to existingsuppliers.

So if we ask a supplierWhat is your netprofitability? and hereplies 9%, is that good,bad or indifferent?

Of course, it all depends.Firstly, a single profitabilityfigure is not really muchuse. It is the trend inprofitability that counts.For example, if thesupplier is making 9%profit this year, but it was10% last year, and 11%the year before that, theinterpretation of the figure

he has given in reply to the

question is going to be

very different, in light ofthat information.Secondly, profitabilityvaries from industry toindustry, and from time totime.

So which industries arethe most profitable?

Gross

margin

Net

Margin

Software 54 21

CommsServices

51 6

CommsEquipment 42 12

Technology 38 15

S & P 500 38 11

Services 35 7

Utilities 27 9

Energy 24 11

Transport 24 8

Airlines 22 3

Retail 22 2

FinancialServices

21 20

BasicMaterials

19 8

CapitalGoods

16 6

Cstruction 14 8

Car/TruckMfacturers

12 4

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The data in the table on

the previous page showsthat gross and netprofitability varies fromsector to sector. Profitalso varies from time totime, and individualcompanies within eachsector may make more orless than the average oftheir competitors. Forexample, whilst a 9% net

profit in transportation canbe considered a goodresult, it could at the sametime be seen as a disasterin the financial servicessector. In terms of timing,it would be reasonable toexpect that manycompanies have haddepressed profits in theperiod following the recentglobal financial crisis, andshareholders who haveendured below-averagereturns as a result, mightreasonably be expectingsome recovery inprofitability in theirinvestments in theforeseeable future.Therefore these figures

shown may not reflectwhat is currently beingachieved by all companiesin each sector.

Whats a fair Profit?Fairness cannot bemeasured with aspreadsheet. We cannot

complain that if our

supplier is making more

profit than we are, that it isnot fair!. Chiselingsuppliers margins andraising the bar in terms ofthe cost to serve ouraccount, should not leaveus surprised if our accountbecomes less attractive tothe supplier as a result.[Cost to serve is aderivation of activity based

costing which includes allthe account servicing costsin the supply chain, overand above the invoiceprice of the goods orservice.]

Research on the realcosts of servicing accountssuggests that up to 20% of

customer orders areserviced at a loss, andmore than 10% of allcustomers areunprofitable. This isbecause suppliers do nothave information systemscapable of tracking theprofitability of individualaccounts, and so adoptaverage pricing to all theiraccounts. The chart

above shows that not all

accounts are createdequal; some are moreattractive to suppliers thanothers. The point is thatwhile a supplier may makean average net profit of9%, individual customeraccounts will be more orless profitable than theoverall average.

The rationale is that largeraccounts typicallyunderstand their scale witha supplier and therelentless leveraging ofscale by buyers depressesthe profitability of somelarger accounts. Ofcourse, this is not true ofall accounts, but where thesales team have protectedtheir margins, or where thebuyer has not appreciatedthe significance of theiraccount, the account maybe more profitable. Ingeneral, smaller accountsmay be less profitable thanlarger accounts, not justbecause the volumes arelower, but because there

will be some sales andsupport costs which arerelatively fixed or semi-variable. For example, adelivery of one box ofcopier paper still needs tobe picked, packed anddelivered in a van with adriver, while a delivery oftwo boxes of copier paperincurs the same costs, but

with twice the revenue.

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Is 9% profit fair?

Many buyers believe thatas long as suppliers maketheir profits from othercustomers that is OK andfair. But the lesson fromthe chart is that it is thecustomers who are theleast profitable who aremost marginal, and asinformation systems allow

suppliers to measure thecost to serve individualcustomers, they will seekto align pricing to the costto serve differentcustomers. Perhaps itmay be better to chiselwaste or try to reduce thecost to serve, than tochisel profitability? But ifyou are a middle rankingcustomer, falling between0.5% and 2.5% of asuppliers total sales,maybe you shouldconsider how profitableyour account really is tothe supplier.

Paul Rogers is a freelance

procurement consultantwww.paulrogers.pro

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Measuring Performance Silver and Gold