Pathways to Profitability

Pathways to Profitability

Boosting dealer profit margins is more about having a business plan that allows for better gross margin and operating expense management than increasing sales volume, say experts.

BY BARBARA CAPELLA LOEHR

If the number of projects a kitchen and bath dealer does in a year is high, then that should translate into automatic profit, shouldn't it? If it doesn't, then a dealer needs to simply go out and generate more jobs, right?

Not necessarily. A large number of projects doesn't always add up to a large profitability numbers. And dealers should be wary of generating jobs that will simply cover their costs.

That's according to several experts on profit margins: Stephen Vlachos with CBI in Portland, ME; Ken Peterson, CKD and president of the Chapel Hill, NC-based SEN Buying Group, and Kitchen & Bath Design News columnist; Thompson Price, CKD, CBD, CR and president of Callier & Thompson Kitchens and Baths in St. Louis, MO; Dennis Dixon of Flagstaff, AZ-based Dixon Ventures, Inc.; and Morton Block, CMKBD, IIDA and president of Kennett Square, PA-based Morton Block Associates.

These experts stress that, in order for dealers to increase their profit ma rgins, they must be aware of more than just the number of jobs they complete annually. Dealers should be looking at everything from general overhead, labor/subs and salaries/benefits to marketing to determine the best areas for investment and most likely areas for cutting costs in order to increase their profit margins.

The NKBA agrees, noting in its most recent Dealer Profit Report (2002), "Profit margin focuses on sales productivity, gross margin management and operating expense control."

SPEAKING of figures
But, before dealers start investing or cutting to boost profit margins, they need to analyze their financial statements, including their income breakdown and balance sheet, to determine what profit margins they need to meet in order to break even and what they will need to be profitable.

According to the same NKBA report, "The income statement summarizes the income and outgo of funds for the entire year. It reflects the ability of management to make sales, control expenses and thereby earn profit. The income statement serves as a 'report card' for management's performance over the year. The level of performance depends primarily upon control of two areas: gross margin and operating expenses."

The NKBA report's income statement section (see table at right) shows that for a typical NKBA dealer with a typical sales volume of $1,537,858 and an annual sales growth of 5.0%, the average gross profit margin would be 36.1% .

"Gross margin, the first measure of profitability, considers all expenses related to the cost of buying and installing the products sold," explains the NKBA report.

It further indicates that the average operating profit is 2.6%, which takes into account the total cost of goods sold; the total payroll expenses; the total occupancy expenses, and the total of other operating expenses.
The report finally boils these figures down to an average profit before taxes of 2.5% for a typical NKBA dealer, which takes into account -0.1% of what the NKBA terms "other income/expenses" (see graph, Page 68).

However, simply going by an average gross profit margin and average profit before taxes may not be the best bet for
dealers today.

"In my judgment the term 'current industry standard' is a terrible misnomer," believes Peterson. "About 25 years ago, NKBA then AIKD determined that kitchen dealers should earn a 40% gross profit. That 'standard' is misleading because it applies more to the mid- to-high-end dealers who perform the turnkey remodeling services package where the degree of difficulty in producing these type of jobs is substantially greater than furnishing a materials-only package to builders.

"Dealers who supply product only to builders are likely to have a very different overhead structure than dealers who do turnkey remodeling. Therefore, their gross profit margins might be lower to earn an equivalent net profit," Peterson continues.

Based on the many financial statements Peterson analyzes each year, and the Financial Statement Comparisons that SEN does for its membership twice a year, he remarks, "The 'current industry average' for all dealer business models is a 35% gross profit margin. And, again, from experience, 35% is not a high enough gross profit average because the vast majority of kitchen and bath dealers fail to achieve enough net profit for the risk of being in business."

Thompson agrees, noting, "NKBA number is low, at around 36%. I would absolutely tell you that 40% is the number to reach, but it is the absolute minimum We start at 44%, 45% and 46% for each job, and hope we come out at 40% or 42%."

"[However], I have always believed that the standard was around 40%," Vlachos chimes in. "This, of course, is for the traditional kitchen and bath dealer who works with consumers. I have done a number of business valuations of all sorts of firms and found that those firms that offer some design services and market mostly to building contractors can be successful at 36%. Other firms that offer no or limited design services can go as low as 30% and still be profitable. It all depends on the service level that the firm offers. Obviously, the more services, the higher the margin needs to be."

"[Profit margins] all depend on volume. So, for example, 33% on $1 million is a nice return, but 33% on $300,000 is not. So, total volume does have an effect on profit margins," adds Block.

However, according to Peterson, there needs to be a shift of focus and incentives from sales volume to gross profit margins. This starts with a shift in the dealer-owner's mindset.

"Too much emphasis is put on sales volume. The more a firm sells, the greater the cost of sales and, with it, the greater the risk of error by all parties involved, including sales designers, vendors, truck drivers, project managers, installers and subcontractors. As a result, gross margins often decrease as sales volume grows. Additionally, there are the variable overhead expenses of commissions, payroll taxes, etc., that increase with sales volume, shrinking the net profit still further," says Peterson.

Indeed, dealers need to assess their own operating expenses and total sales volume to be able to determine the right gross profit margin and, in turn, their profit before taxes. But exactly how should dealers calculate their target profit margins?
"[Start with a] pricing formula i.e., mark-up [which] should be a direct function of the annual budgeted overhead, a fair market salary for the job they perform as the dealer-owner and their desired net profit," says Peterson. He further notes that there are six steps that should be followed to develop the correct gross profit margin for a firm, regardless of its selected business format (see table, Page 66).

The six steps outlined in the table are listed in the order they should be done, says Peterson. In contrast, many dealers actually determine their gross profit margin differently, using the same steps listed in the table, but starting with step one, followed by steps four, five, six, three and two. If dealers were to follow these six steps in the order indicated in the table, Peterson believes dealers would end up with more accurate figures.

Additionally, Vlachos advises that "every dealer should look to put 10% on their bottom line. So, add up your costs, use your multiplier to determine sales price and then deduct expenses to make sure you end up at 10%. If you do not, then you have not added enough margin to your costs. Unfortunately, many dealers worry more about the competition's pricing than about their own profitability. The focus should be solely on profitability. If you maintain profitability, but find that the competition is stealing jobs, the problem is not in how you charge, but probably in how you are buying."

PLANNING AHEAD
Another piece of the profit puzzle is putting a solid business plan in place. "Dealers should have a business plan in place, especially when tabulating their overhead and other costs," says Block. "You need to be able to see the historical data and where you are today. The plan should include everything you have now and want to do, such as showroom expansion, additional locations, etc. Then, determine the amount of sales it will take to meet your goals, and forecast profit to see if it stacks up to operating expenses."

In addition, "call on consultants such as accountants and financial advisers and get their analysis. It may cost more but a good consultant who understands the industry is worth the money," Block notes.

"An investment of time and money in a strategic plan with a qualified business and/or marketing consultant can pay major dividends," agrees Peterson. "For one thing, it will determine the three to four uniqueness factors that should be promoted about your firm and which media will deliver the most cost-effective results."

When dealers are outlining a business plan and analyzing numbers, they need to avoid some common profit pitfalls, say Vlachos, Peterson, Price, Dixon and Block. They include:

  • Having too much focus on sales volume and selling jobs to generate cash flow.
  • Not understanding the value of certain products versus others.
  • Having no price formula based upon annual budget, and not pricing jobs correctly.
  • Not collecting enough money at the start of the project.
  • Lacking good service (i.e., slow response to problems, etc.).
  • Continuing to deal with subs or suppliers who don't perform.
  • Having an inadequate marketing plan.

"They can avoid these pitfalls by joining an industry organization that offers services to dealers in fulfilling all of these critical needs," stresses Peterson. He further suggests attending industry-specific seminars on business management.

PROFIT PRACTICES
Once dealers have reviewed their financials, outlined a business plan and calculated a profit margin that works specifically for their firm, they can then start implementing practices that boost their profitability.

Vlachos, Peterson, Price, Dixon and Block all have many tried-and-true ways of improving profit margins that range from investing to cost-cutting measures (see related story, below).

However, all recommend that before doing anything, dealers should examine the pros and cons of each investment or cost-cutting measure they consider. As Peterson explains: "Dealers should always weigh the quantitative and qualitative results. Quantitatively, they should project their return on investment: Extra Gross Profit Dollars - Extra Overhead Dollars รท Investment Dollars). Qualitatively, they should evaluate how well the idea satisfies a particular critical success factor that gets them closer to achieving their vision for the business. If both results are positive and congruent, then that makes for
a sound business decision."

Dealers should also be careful what costs they cut in the short term because they could cost them more in the long run.
"Be careful not to cut critical expenses, such as advertising, education and training, and keep an eye on areas such as travel and entertainment," advises Block.

Price agrees, noting the importance of advertising and marketing. "It doesn't cost a penny if it's done right. You may need to put 2% to 3%, maybe upwards of 5%, toward marketing tools and advertising, depending on the firm size... And, there are so many low-cost ways to advertise and promote a business." For instance, he cites speaking at local home builder shows and contacting your local newspapers with design story ideas.

"I usually operate on the premise that you need to invest money to make money. To me, it is better to grow and earn more money than to try and cut back to save money. That does not mean that understanding your true costs isn't important. Instead, cutting hours, cutting employees, etc., are usually not great long-term ways to boost profits," adds Vlachos.
Thompson also relates a practice that has worked for his firm over the years: "We base our sales commissions on profitability, not on the sale. We work on a sliding scale the higher the profitability, the more commission."

Selling upgrades, having written job specs, billing for change-orders up front and expanding product offerings are also ways in which dealers could increase their profit margins, say Vlachos, Peterson, Price, Dixon and Block.

Despite the fact that, in some cases, certain product mark-ups may not seem as profitable, they recommend that dealers consider selling as many products as they can instead of sending their clients to home centers and other product distributors, such as appliance distributors. KBDN

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