Wednesday, October 29, 2008

Huge sales = huge bonuses. But not profits....

I have always assumed that what was true on a micro level, small stores, was probably true on the macro level, large corporations. At least, certain fundamental principles and concepts.

Which is why I have always been skeptical of huge, out-sized profits, and the huge, out-sized bonuses that go along with them.

I've seen this happen over and over and over again through the years.

A new competitor opens, usually with the announcement that they will do business 'right' (thereby implying, I'm doing it 'wrong.') They are newer, shinier, with better inventory and cheaper prices; they are nicer and handsomer than me.

Soon I get reports about how 'well' they're doing, how much money they're making. They are expanding, buying a van, going on trips to trade-shows.

Inevitably, my customers will start to question me: why don't you do such and such, like they do? Look how successful they are!

(Not to get into details, but the answer to every 'why don't you' is always, time, energy, space and money.)

And then, the worm turns.

I start to get reports that "they don't have as much as they used to..."

Or..."the owner isn't there as much, and he's kind of grumpy...) (...and not as handsome, I presume.)

"They raised their prices...."


Heres' what was happening behind the scenes. They were taking those marginal profits and instead of reinvesting in the store, they were churning the money into more product that they turned over fast and didn't make a profit on which they took the money and churned it again.

Or they spent the money on themselves or on unnecessary flourishes in their store.

What they weren't doing -- reinvesting in the future. Getting a realistic margin that allowed them to replace inventory, pay the bills.

It's relatively easy to make short term sales, if you don't care about margins and reinvestment.

10 comments:

Duncan McGeary said...

What brought this up was a conversation yesterday with a new store owner (not a competitor) who horrified me by telling me how much cheaper he was than the competing mass market store.

What horrified me was that his margin was a minimum of 1/3rd less than he should be shooting for as a mom and pop; and that he could raise his margin and still be very competitive with the mass market. (Something I usually can't do; I feel like I've succeeded if I can get within 10% over the mass market in price...)

I showed him the 'break-even' formula (fixed expenses divided by profit margin) and how he had to earn twice as much money as me to reach the same goal.

But he said he still had money left over at the end of the month.

I shrugged.

The 'break-even' formula is incontravertable. Either his margin is higher than he thinks, or....and this is what I suspect, his inventory is being squashed.

Inventory gets old and stale and frayed around the edges. That's where your loss is probably happening and it takes forever to see it.

But eventually, it catches up. You can't quite replace the inventory at the levels you used to -- because your margin isn't sufficient.

Being a nice guy to customers is useless unless you can stay in business, right?

I don't think he listened to me. But I didn't mind being the old crusty guy, because I think down the road, when it comes to the crunch, he may actually remember that someone told him about it.

Duncan McGeary said...

I know this, because I went through it too. The temptation to be a hero to your customers, to be nice by having the lowest possible prices.

I came to my senses just in time.

As I said to him, there is nothing wrong with making money.

It's not money that will go into your pocket -- as a mom and pop you'll make a modest living -- but money that you'll need for your store, for the future, to diversify, and replace, and so on...

Not only isn't there anything wrong with getting a proper margin, it's absolutely necessary.

Duncan McGeary said...

The irony is that my wife, is so much nicer than me in most ways, has never had a problem with getting the right margin.

We are a good combo in that way -- she's much more realistic.

Duncan McGeary said...

But what about selling more at lower prices?

The break-even formula takes care of that.

I haven't found it to be true, mostly. If you lower your prices by 20% on a 40% margin, you have to sell twice as much. And usually, 20% isn't enough to do that.

That works up and down the scale.

I think a mom and pop is better off shooting for quality not quantity.

Quantity requires a huge outlay, and tons of risk. Even when it works in the short term (every fad is in a sense a quantity formula) supply always catches up to demand, competition always rears its head, and suddenly you're stuck with a small margin without the large sales.

It's one of those things that goes against the common wisdom of the customers; who have had it drilled in their heads that the lower the price the higher the sales.

But only if the formula works. And you have to plan for when the formula might change.

Duncan McGeary said...

Another example, you lower the prices by 35% on a 50% margin. You have to sell over 3 and a half times as much product, and invest even more.

At 50% off for a 50% margin, you have to sell to infinity and never make a dime.

Duncan McGeary said...

Or a 30% off price from a 40% margin. You have to sell 5 times more material. You have to invest (and risk) 10 times more money. Not to mention find space, time, and energy to deal with that much more material.

But your customers will love you.

RDC said...

How many inventory turns was he getting?

I usually use an estimate of 12 per year for a mass market store

Walmart does considerably better then that.

The margin calculation can be dramatically impacted by inventory turns. (if you have to sell somthing three times to break even of the original capital investment and you do 12 turns you are break even on a capital investment after 3 months and yield a 300% return at the end of the year on the capital investment. Spread that over expenses and well you get the idea)

I suspect your store is in the 2-4 range at best.

What kind of store was it and what kind of inventory turns do you think he is running?

RDC said...

The previous amount on inventory turns relates to relatively minor variations in margins. Like going from 40% to 35% gross margin for example. I can accept a 25% margin if I can get sufficient inventory turns. A store that gets 12 turns with a 25% gross mrgin yields a cash flow of 300% of capital investment for the item.

On the other hand if I do 3 inventory turns then even at a 40% margin my cash flow is only 120% or just 20% return on the cost of the product.

That is why in mainstream stores their success is very much determined by product selection and why they do not take much risk in the variety of items offered.

Michael said...

Quote from Duncan:
"Inventory gets old and stale and frayed around the edges. That's where your loss is probably happening and it takes forever to see it.

But eventually, it catches up. You can't quite replace the inventory at the levels you used to -- because your margin isn't sufficient."

__________

If you replace the word inventory with debt you have a good look at our economies real problem. Debt we will never retire, always pay on using more debt we can sell for less and less.

__________
I've ran and owned restaurants for 20 years. Sold out 18 months ago and have been working as a consultant. The lack of understanding of basic business accounting and P and L statements never ceases to astonish me. Rarely do I find a restaurant that is managing their inventory or aware of the costs involved/wastage in turnover rate.

Inventory management is the secret of success or failure in most businesses.

Anonymous said...

No ax to grind bebb.

The issue is the truth, the issue is a free and fair debate about our city.

The issue is the Source & Bulletin have had nada on this subject.

The issue is that the city has sold Juniper Ridge to Suterra in a secret deal, see juniper-ridge-info.blogspot.com

Regarding biology and axes to grind not one iota of content needed to be created, there are ten's of thousands of references of Suterra's handiwork all over the internet. Spraying on the google campus itself has created a cottage industry of websites dedicated to making Suterra's poisons public.

Many people who work at google commute to Santa Cruz & Monterey, which was especially hard-hit by Suterra poison.

The essential issue with Bend is that over 50% of the voting public voted for Bush/Cheney which funded this spraying operation, while the majority of the Bay Area hates Bush-Cheney. The majority of Bend loves Bush-Cheney. This is the reason for the silence in Bend.

This debate has NOTHING to do with Suterra BEBB, it has only to do with Bush-Cheney's secret projects, its just frosting on the cake that Suterra got a $500M no-bid contract from Gov Schwarznegger courtesy of USDA aka Bush-Cheney & homeland security.

It's just icing on the cake that Schwarzneggers largest campaign contributor "stewart resnick", OWN's Suterra.


These are all public facts that need to be TATTOOED on the ass of the Bend citizenry.