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Hey, The Truck Is Going Right By There Anyway!

Incremental sales opportunities

By Albert D. Bates, Ph.D.

Incremental sales volume is the great white whale of distribution management. This means that very few managers have actually seen it, but they have spent a lot of time, effort and even sorrow in the search. If they do find it, the results frequently are not what was anticipated.

Theoretically, incremental volume is additional sales that can be generated without incurring any increase in expenses. In practice, incremental volume is more often an increase in sales that can be achieved with only a modest increase in expenses.

Incremental volume is frequently expressed by the idea that if the delivery truck is going right by a potential customer, then the cost of making an additional stop is very low. Similarly, direct shipments are often viewed as situations where the firm only “has to sell and carry the accounts receivable for a little while.”

The problem with the incremental volume concept is that in the overwhelming majority of cases, the costs associated with servicing the sale tend to be underestimated. Further, the idea of a “cost-free” sale too often leads to serious margin erosions. The combination of higher-than-planned expenses and a low gross margin is almost always disastrous.

The Economics of Incremental Volume
Exhibit 1 looks at the economic impact of incremental volume, under present conditions and for three different scenarios. The first column presents the financial position of the typical MHEDA member as reported in the Distributor Performance Benchmarking Report. As can be seen, the firm has $10 million in sales, operates on a gross margin of 45% of sales, and produces a bottom line profit of $500,000 or 5% of sales.

Exhibit 1
The Impact of Incremental Sales Volume Under Different Expense and Margin Scenarios

		10% Incremental Sales Volume
	Current Results		Scenario One	Scenario Two	Scenario Three
Net Sales	$10,000,000		$1,000,000	$1,000,000	$850,000
Cost of Goods Sold	5,500,000		550,000	550,000	550,000
Gross Margin	4,500,000		450,000	450,000	300,000
Fixed Expenses	3,200,000		0	256,000	256,000
Variable Expenses	800,000		80,000	80,000	68,000
Total Expenses	4,000,000		80,000	336,000	324,000
Profit Before Taxes	$500,000		$370,000	$114,000	-$24,000

Profit Percentage	5.0%		37.0%	11.4%	-2.8%


Net Sales	$10,000,000		$11,000,000	$11,000,000	$10,850,000
Cost of Goods Sold	5,500,000		6,050,000	6,050,000	6,050,000
Gross Margin	4,500,000		4,950,000	4,950,000	4,800,000
Fixed Expenses	3,200,000		3,200,000	3,456,000	3,456,000
Variable Expenses	800,000		880,000	880,000	868,000
Total Expenses	4,000,000		4,080,000	4,336,000	4,324,000
Profit Before Taxes	$500,000		$870,000	$614,000	$476,000

Profit Percentage	5.0%		7.9%	5.6%	4.4%

The firm's expenses have also been broken down into fixed and variable expenses. The variable expenses, such as commissions, overtime and bad debts, can be expected to increase directly with sales, even with incremental volume. These variable expenses have been estimated as being 8% of sales.

Fixed expenses, in contrast, are those that could normally be expected to remain constant as sales increase. These include a litany of factors, such as operating and administrative salaries, rent, utilities and depreciation.

The last three columns of numbers represent the impact of a 10% increase in sales under three different scenarios. In all three columns, the top half of the exhibit presents the results of the incremental volume by itself. The bottom half represents the overall impact on the firm with the incremental volume, margin and expenses added to the total.

Scenario One is a pure, theoretical, incremental approach. Sales are up by 10% with the same gross margin percentage as before. Of greatest consequence, fixed expenses do not increase at all. The profit impact is nothing short of spectacular. The only problem is that a 10% increase in sales is a large jump to have absolutely no associated increase in fixed expenses.

For very small amounts of incremental sales, the first scenario can prove appropriate, especially in the short run. However, when there is any significant amount of incremental volume—and 10% definitely qualifies as significant—the fixed expenses inevitably increase.

Scenario Two combines the 10% sales increase with an 8% increase in fixed expenses. The idea of sales rising faster than expenses is commonly called expense leveraging. The 2% level of expense leveraging in Scenario Two (10% sales increase, 8% increase in fixed expenses) represents good performance in most distribution firms. There is still a measurable improvement in profit, but it is much more modest.

Profitable Incremental Sales Opportunities

Incremental sales can be generated in an almost infinite number of ways. The most common ways are listed below. They are listed from most likely to produce high profits to least likely. Ideally, this would represent the focus of distributors in trying to enhance sales.

Invoice Loading — The classic strategy of trying to add an additional line to every invoice remains the most profitable way to drive incremental sales. It involves no more delivery stops, no more orders picked (simply more lines) and virtually no increase in fixed expenses. It also has the strategic advantage of taking volume from competitors.

Product Line Extensions — Offering additional products can produce additional sales, but there is always an expense in purchasing, selling and supporting new products. If the effort is geared toward current accounts, though, the profit increase is almost always substantial.

New Customers at Existing Margins — The cost of finding and servicing new customers is typically higher than estimated. From a market share perspective, though, it is the major competitive thrust.

Direct Shipments — Ideally, these should be a major source of additional profits. The reality is that such efforts are almost always under-priced as the costs associated with handling such sales are always underestimated. Great care needs to be taken in this arena.

New Customers at Lower Margins — The lure of large volume at lower prices is almost always fatal.

Scenario Three represents the real problem with incremental volume—a mutation into price cutting. In this example, the incremental sales are achieved by lowering prices on the incremental sales by 15%. This means the incremental volume has a gross margin of only 35.3%, rather than 45.0%. The logic is that the fixed expenses have been covered, so the firm can lower its prices to generate the additional volume. However, when the price is reduced, even with expense leveraging, the profitability of the incremental sales effort is destroyed.

Controlling Incremental Sales
Exhibit 1 reflects the two things that management must continually focus on to ensure that incremental sales are really profitable. They are the two things that are seldom accounted for properly.

First, expense estimates associated with incremental sales should always be increased. This is because expenses are always under-estimated. Even for direct shipments, there is more than simply selling and collecting. There are always returns to handle, product functions to explain and myriad other costs. When costs are higher than planned, profits quickly drain away.

Second, it should be remembered that gross margin is king in distribution. Any program that requires a significant reduction in gross margin should be avoided. It is always tempting to assume that if expenses are low, then margins can be lowered and an adequate profit generated. For most firms, this is a myth.

There is another, highly strategic problem with low gross margins on incremental sales. As soon as one sale is made at a low margin, it is tempting to make a second, then a third. Ultimately, there is no stopping point on the slippery slope of gross margin reductions.

Moving Forward
If managed properly, incremental sales volume can be an important profit driver for MHEDA members. The problem is that proper management is extremely difficult to maintain in the face of “pure add-on” sales volume. The larger the opportunity, the more difficult the situation is to control.

Firms must make sure that they properly assess the true expense relationships associated with incremental sales. Further, they must always be aware that gross margin is the single most important driver of profitability. When gross margin falls even a little, profit falls a lot.

Meet the Author
	Albert D. Bates, Ph.D., is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado, and on the Web at www.profitplanninggroup.com.