Incremental Improvement for the Biz - Part 3

The goal is not to suggest one-time breakthroughs in business financial results but to focus on incremental long-term improvements that will drive superior performance over a five-year or longer period. Starting with developing a 'critical number' to benchmark the organization's performance (financial or non-financial), then developing strategies and tactics to improve it over time. As a default, I recommend (and one we've taught at the Wisconsin School of Business in Entrepreneurial Management for several decades) is Return on Assets Invested (ROAI).

Previously, we discussed increasing ROAI via increasing prices on products or services as one way to increase ROAI. Our example showed that a 6% increase in prices would obtain a 20% ROAI (assuming nothing else changes). A second way to increase ROAI is to increase sales volume. In this scenario, we'll examine the changes in bottom-line ROAI based on increasing sales volume in the form of customers or invoices and hold all other variables constant.

Strategy 2 - Increase Sale Volume to Get Higher ROAI

Using the same parameters, how much does volume need to increase ROAI from 12.5% to 20%. Recall that:

1. ROAI = (EBIT / Asset Investment), can be restated as ROAI = (EBIT/Sales) x (Sales/Asset Investment), which is Operating Margin x Asset Utilization.

2. Dividing Operating Margin further Operating Margin or EBIT/Sales is comprised of:

   1. (Sales - Variable Costs - Fixed Costs)/Sales.

   2.  Sales $ can be divided into (Price per unit x Volume) and Variable Costs into (Variable Cost per Unit x Volume)

Using the data from a previous blog post:

Revenues $500,000 (Price per Invoice $250/Invoice x 2000 Invoices)

Cost of Goods Sold $240,000 (Variable) or 48% of Revenue ($240,000/500,000)

Other Variable Expenses $60,000 (Variable) or 12% of Revenue (60,000/500,000)

Contribution Margin = Revenues - Variable Costs = 500,000-300,000 = 200,000, 40% of Revenue

Operating Expenses $150,000 (Fixed)

EBIT = $50,000

Assets Invested $400,000

ROAI = 12.5%

When an increase in volume occurs, there's an impact but less than a price increase because variable costs change directly with volume in sales as the Cost of Goods Sold + Other Variable Expenses equals total Variable costs of $300,000 or 60% of Revenue. Thus, for each $1 of Sales Change, Variable Costs will change by $0.60.

To get to the 20% ROAI, we need an increase of $30,000 in EBIT where EBIT = $80,000/Asset Invested+$400,000. Contribution Margin in this example and the change needed would require an increase of $30,000 to achieve the 20% ROAI. Using the Contribution Margin equation:

• Increase Needed in Contribution Margin = 30,000,

• Change in Contribution Margin = Change in (Sales - Variable Costs) = 30,000, further deconstructing Contribution Margin,

• (Price/Unit) x Volume) - (VC per Unit x Volume) = 30,000

• Change in Volume x (Price/Unit) - VC/Unit) = 30,000

• Change In Volume x ($250/unit - $150/Unit at 60% of Sale) = $30,000

• {(Change in volume) x ($100/Unit) }/$100/unit = $30,000/$100/unit

• Change in Volume = 300 units needed to obtain the needed increase of $30,000 in CM, thus, a 15% increase in Volume is needed.

Original Volume of 2000 Invoices + 300 Invoices Need = 2300 or ((2300-2000)/2000) of 15%.

To Check:

• Revenue = Price x New Volume = $250 x 2300 = $575,000

• Variable Costs at 60% of Revenue = 60% x 575,000 = $345,000

• Contribution Margin = $230,000

• Fixed Costs = $150,000

• EBIT = $80,000

• Assets Invested = $400,000
  

ROAI New = $80,000/$400,000 = 20%

Change in Sales Volume - A Reality Check

In reality, most markets will not allow an increase in sales volume without either:

• A corresponding lower price

• Higher Marketing expenses such as commissions, advertising, social media, etc.

• Potential increase in Fixed Expenses due to needing more capacity such as labor, machines, and facilities.

• Lower Unit Costs from Economies of Scale

• Changes in Asset Investment due to needing more funding for accounts receivable, inventory, fixed assets, or other items.

Price vs. Volume - is one better?

In the price example, it only took a 6% increase in pricing to accomplish the 20% ROAI while volume needs to increase 15% to get that same ROAI. Assuming that no other variables change, pricing will always have a more dramatic impact on profitability than volume since with no change in sales volume due to the price increase. The incremental revenue "drops" 1:1 to the EBIT line. Conversely, any profit impact from higher sales volume is partially offset by higher variable expenses as the variable expenses correlate directly with sales volume changes (60% in this example).

Realistically, if a firm needs to quickly turn things around, raising prices can be a viable strategy for quick cash. However, as entrepreneurs will tell you, the fear of losing customers is very real if prices are increased too much. On the other hand, to get volume increases, the firm may need to lower prices and/or dramatically increase marketing spending. And, what happens if you do this and the increased volume doesn't happen?

Recommendation

My recommendation is always to analyze your customers on an individual basis. Ask questions or think of actions like:

1. When was the last time we raised prices for this particular customer? What might be their reaction? Do they buy from us based on things other than just price?

2. Are there 'trouble customers' such as those who complain all the time? Those that require an inordinate amount of service? Customers who return products or services asking for full refunds? If so, maybe raise the price on them and see their reaction. Many times the trouble customers will leave and save your firm time and money.

3. What are the order sizes for each customer? Do they order in ones and twos or are they bulk purchasers? How often do they order? Try to analyze the customers that alter their purchasing behavior to be more cost-efficient.

4. Are your sales based on recurring customer purchases or on new customers? The cost of acquiring new customers is many times the cost of customer retention.

5. Who are your late payers vs. those who pay on time or early? Figure out ways to reward the early payers and to make the later payers want to pay faster.

6. Use discounts where appropriate. Without lowering the list price, periodically use that discount option to make your customers feel good, buy more often, or even buy in greater volumes.

7. Use rebates or incentives. For example, set up annual purchase goals for customers and if they exceed certain amounts, provide a small rebate of 1% or so times their annual sales volume. At the end of the year, cut them a rebate check - they love ya. (and yes, accounting departments hate this).

Those are just some of the potential items to examine in the sales process. The goal is to increase ROAI using steps that enhance sales revenue and/or lower variable expenses. Each decision should be evaluated in what-if scenarios to 'guesstimate' their bottom line impact.

Summary

Two ways to improve ROAI are to increase sales price per unit and/or increase sales volume. In both examples shown so far, changes were dramatic to increase ROAI from 12.5% to 20.0%. Both scenarios were illustrated under assumptions that limited other variables in the ROAI calculation to remaining constant. In a realistic world, we know that this is unusual and very infrequent. As this series continues to emphasize, we aren't after significant changes in one or two quick changes but aiming for limited, incremental improvement over time. In both examples to date, what might the impact be if price changes and/or volume changes were limited to 1% or less? Such minute changes may not reach the overall goal very quickly but can improve performance in small ways.