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The economy appears to be slowly but painfully digging its way out of the recession. As it does so, WMIA members would be well advised to take a cautious approach to both sales growth and expenses. If not, it is possible that firms will repeat the mistakes they made at the end of the last recession.

This article will address what are probably the two most common challenges that distribution organizations face at the beginning of an economic recovery:

• Excessive Growth÷After a painful downturn in sales, firms are naturally salivating for any and all additional volume they can produce. As strange as it may seem, too much growth potentially is just as devastating to the firm as not enough growth. It is essential to have a specific growth plan.

• Loosening the Expense Reigns÷It may seem impossible that firms would suddenly abandon their emphasis on expense control at any time in the near future. However, both human nature and past experience suggest that firms will make up for the foregone raises and salary cuts that were realities during the recession. 

Calculating The Growth Potential Index

The Growth Potential Index (GPI) provides an estimate of the rate by which the firm can increase its sales without eating in to its cash balances. Mathematically the ratio is relatively simple:  

Net Profit After Taxes

Accounts Receivable 

       + 

Inventory 

       ö 

Accounts Payable

The after-tax profit figure in the numerator represents the money that the firm is producing to support additional sales volume. The denominator takes a working capital view of the firm. It indicates that as the firm grows, it will require more inventory and accounts receivable to support that growth, but will also benefit from increased supplier financing.

Excessive Growth

One of the oldest adages in business is that sales growth solves every problem. A more realistic statement would be that sales solves a lot of problems, but also creates a few of its own. In particular, sales growth inevitably leads to increases in accounts receivable and inventory. The result can be a severe, and possibly even dangerous, strain on the firmsâ financial resources, even as profits rise.

In thinking about future sales growth, firms should have a clear idea as to the limits on growth from a financial perspective. For the last several years, the WMIA profitability survey has included the Growth Potential Index as an indicator the rate of growth firms can absorb financially.

Specifically, the ratio indicates the maximum rate at which the firm can grow without beginning to deplete

its cash reserves. It does that by comparing the funds that are coming in from operations to the funds that will be needed to support future sales growth.

At present, the GPI for the typical WMIA member is 7.7%. Again, this does not say growth at a more rapid rate is not possible. It simply indicates that more rapid growth will come at the risk of diminishing the firmâs cash balances. As firms find increased opportunities for sales growth, they should make sure they have the financial resources to support that growth.

Loosening the Expense Reigns

When sales start to climb back up, expenses soon follow. This is especially true for salaries and fringe benefits. Raises have been deferred for some employees and there are often gaps in the employee base that need to be filled. Even the most deliberate of managers yields to expense pressures.

Exhibit 1 suggests why continual caution over expenses is essential. The exhibit assumes that the typical WMIA member is going to grow by 5%, an arbitrary estimate of post-recession growth. The actual number used is unimportant. The real key is the of expense growth required to support that sales growth.

The exhibit presents two very different scenarios on expense 

control, particularly as it relates to payroll and fringe benefits. In both scenarios the sales growth rate is the same 5%, driving sales to $6,300,000.

• Tight Expense Control÷Under this scenario payroll and fringes increase by only 3%. At the same time other expenses increase by 5%, right along with sales. The result is that profits increase by 28.5%, from $90,000 to $115,620. It is a glorious scenario if it occurs.

• Loose Expense Control÷Here payroll and fringe benefits increase by 7%, while other expenses continue to grow right along with sales at 5%. The result is a profit decrease of 18.5%, from $90,000 to $73,380.

Clearly, firms need to maintain diligence on payroll. The fact that they did not do this at the end of the last recession should be a clear call for expense diligence.

Moving Forward

If WMIA members are going to enjoy the benefits of a revived economy, they must do two things. First, they need to carefully plan their growth. Second, they must maintain a focus on expense control for at least an additional year.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.