July, 2006

3 Steps to Stronger Profits

If you’re not paying attention to all the factors that affect gross margin, you may be leaving money on the table—and sacrificing your company’s profit.

By Bill Lee

In my book, Gross Margin: 26 Factors Affecting Your Bottom Line, the first words I wrote were: Gross margin is an attitude.

I learned this and many of the other factors affecting gross margin from a man more than 20 years my senior whose great gift to me was his enthusiasm and appreciation of gross margin control. Some of you may have crossed paths with Wade Hampton Stephens. He and I worked together for more than 10 years.

Stephens taught me that gross margin optimization had to be an attitude instilled in a company’s personnel. He believed that all businesses leave gross profit dollars on the table because they fail to fully appreciate each of the factors that influence gross margin. In the 18 years that I have been a consultant to the lumber and building supply industry, I have found just about everything Stephens taught me 30 years ago is still true today.

1. Buy Better

Improving buying programs goes a long way toward putting a business in a position to raise gross margin, but only when the organization is disciplined enough to hold onto this additional profit. More times than not, however, a buying advantage is not retained in the company, but rather is passed on to customers. The culprit: I call it a markup rut. Or it could just as easily be called a gross margin rut.

Is your company guilty of falling into a markup rut? Most organizations are. It happens when buyers, managers and salespeople alike use a convenient but costly method of arriving at sell prices: the historical percentage. This habit not only robs the company of improvement in its gross margin, but it could actually lower the gross profit dollars the company earns.

2. Learn What the Market Will Bear

Price is like water in that it seeks its own level. To optimize gross margin, companies go through a lot of pricing trial and error to determine how much the market will bear; that is, how much gross margin a product will support before sales decline. By experimenting with higher gross margins of even 1/4% to 1/2%, a company can add literally tens of thousands of dollars to the company’s bottom line that it would otherwise leave on the table.

How much business do you believe your company would lose if you raised all of your prices by, say, one percentage point? If you were successful, how much additional profit would such a move put on your company’s bottom line?

The late Lanny Moore, founder of Fort Myers, Fla.-based Suncoast Contractors Supply, was a gross margin expert. Lanny understood gross margin control perhaps more thoroughly than any owner I ever met. Several times a day he would go to the printer and pull a control copy.

He would look at the gross margin of every sku. If he saw anything that had what he perceived to be an unsatisfactory margin, he’d find out what caused it. Did someone make a keypunch error when the sku was received into the system? Did a salesperson make a pricing error? He’d ask the salesperson and the buyer; he’d check the last purchase to find out. Whatever it was, he’d get to the bottom of it.

Although Lanny achieved optimal gross margins in every operation he managed, he never allowed himself to become content; he continually looked for ways to squeeze out of the market another point or two of gross margin, and without necessarily raising prices. Lanny exemplified what I mean when I say that gross margin must be an attitude.

3. Target Your Gross Margin Opportunities

The key to generating optimum gross margins is to focus on the areas that can yield better numbers and to take action against the pitfalls that are costing you money. For example: Special-order sales. Special-order sales represent an outstanding opportunity to boost gross margin. The rule of thumb for most businesses I work with is for special-order sales to account for 20% to 25% of total sales. And who prices special-order sales? Nine times out of ten, it’s the inside or outside salespeople who decide how much to mark up or how much gross margin to earn on special-order sales.

My research shows that not only are most salespeople in a rut with regard to how they arrive at sell prices, but in virtually all organizations there is also around a 6% spread between the salesperson with the most courage and the salesperson who is the most timid at setting sell prices. In other words, one salesperson might earn 25% on a given special-order sale and another selling the same products to the same class of trade will earn 31%. Go figure!

Action Plan: Call a meeting of all salespeople involved in special-order sales and present a list of each special-order product that together make up 80% of your company’s special-order sales. Next, review each product and agree among the salespeople on an optimal price to present for each special-order item. This procedure will allow a great deal more consistency among salespeople and will result in a substantially higher gross margin for the company.

Employee guilt. Employee guilt is a factor that plays a huge role in preventing companies from optimizing gross margin. While employees may not discuss their guilt feelings with management, I assure you that guilt feelings are alive and well in virtually all lumberyards. The guilt arises from the belief that a markup or gross margin above a given amount is tantamount to gouging the customer.

Gouging! What an emotion-packed word! No salesperson wants to gouge on the selling end and certainly no customer wants to be gouged on the buying end. The secret to overcoming these guilt feelings is for management to do a better job of communicating. When salespeople are required to guess their company’s level of profitability, they almost always guess too high, sometimes into the stratosphere.

One guilt-ridden salesperson told me, "My customers are struggling to keep their heads above water. Yet it’s obvious that the owner of my company is rich. I see what kind of house he lives in, what kind of car he drives and where he and his family go on vacation. When I see the disparity between what my customers earn and what my owner earns, I feel just plain guilty over 20% to 25% markups.”

Little did this salesperson know that neither the owner nor the company was "rich” at all, but instead had lost money in each of the past three years. His owner may have given the appearance of being wealthy, but because the owner kept his financial problems a secret, this salesperson had no clue as to the true picture.

Most residential homebuilders take a substantially higher net margin to the bank than the great majority of LBM businesses. In fact, the average lumber company earns between 2-1/2% and 3% before taxes, which is hardly what I would call gouging. Our industry needs higher gross margins, not lower.

Action Plan: Review with each salesperson how little your company takes to the bank on a $100 sale. Make sure that your salespeople know the truth about our industry’s profitability.

Product mix. Some product categories naturally carry higher gross margins than others, so salespeople who are committed to selling the entire house package will always produce higher margins than those who focus strictly on selling sticks. The secret is for management to work with all salespeople to improve their product mix.

Action Plan: Develop and track a Penetration Index that lists each major product category down the left side of the page and each customer across the top of the page, creating a grid by customer that allows managers to quickly identify the major product categories each customer is buying—and which ones they are not buying.

It’s the sales force’s job to sell the complete product line, not just the lines they feel comfortable selling or want to sell. If the company operates a manufacturing or assembly facility, then it’s the sales force’s job to sell the capacity of these facilities.

Insist that your salespeople maintain the Penetration Index on each of their customers and submit to their manager the obstacles they believe are preventing them from selling each category to each customer who is not buying.

Sell up. As a rule of thumb, the more premium the product, the higher the gross margin, so salespeople who possess the product knowledge and the sales skills to convince builders that they can add more value to their homes by upgrading to more premium products will generate higher gross margins. And at the same time, selling up puts customers in a better position to set themselves apart from the competitors who are still selling on price.

Action Plan: Invite your salespeople who do the best job of upgrading a sale to make a presentation at sales meetings. Keep your salespeople focused on higher margin opportunities.

Reward higher gross margins. If you’re going to pay salespeople a commission, they had better be money-motivated, because salespeople who aren’t will rarely push themselves hard enough to become top producers. But all commission plans should be designed to reward salespeople for producing higher gross margins. Paying a straight salary or a commission tied strictly to sales provides no motivation to optimize gross margin.

Personally, I like a commission plan that pays a percentage of sales, but tied to the monthly gross margin each individual salesperson generates. The higher the gross margin, the higher the sales commission.

Action Plan: Make sure your commission plan includes gross margin and make sure that the salespeople you hire are "hungry.” When salespeople become content with their income, they resist making the extra effort to improve results.

Track gross margin results by computer. All industry-specific computer systems produce excellent sales and gross margin reports: gross margin by salesperson, customer, job, major category, minor category, individual sku, gross margin exception, etc. These reports give management the timely information it needs to make decisions that will have a positive influence on gross margin, plus spot oversights that negatively affect gross margin.

Action Plan: Assign someone in your organization to scrutinize each gross margin report. On special-orders, set the minimum gross margin at 99% to force each special-order sale to kick out a gross margin exception report.

Compare apples to apples. Contractors tend to look at the bottom line when comparing quotations; infrequently will they scrutinize the specific items that make up each supplier’s bid. Salespeople who are too timid to ask customers to allow them to perform an apples-to-apples comparison before reacting to a competitive bid will almost invariably leave gross margin on the table.

Rarely will all competitors bid the same grade, specie or brand as you are bidding. Sometimes the low bidder will accidentally or on purpose leave a few items off the bid. Any of these possibilities can cause your company to appear to be high bidder on a job on which the contractor is not comparing apples to apples.

Action Plan: Each time a customer gives you a copy of a competitor’s bid, save it in a file, along with your company’s bid on the same job. By comparing dozens of competitors’ bids with yours, you can easily illustrate to both your customers and your sales force the benefit of taking the time to do apples-to-apples comparisons.

Stand by your prices. The sales force’s skill level at defending prices is number one in a company’s quest for higher gross margins. In my Gross Margin book I provide a great deal of detail on how salespeople can best deal with pricing objections, but the effort begins with a dose of reality: Just because customers and prospects tell salespeople that their prices are high doesn’t necessarily mean that their prices are high. It’s a fact that customers and prospects will tell salespeople that their prices are high when they are not high—even when prices are competitive or below market.

Contractors do this because our industry has taught them well; they have learned that if they kick and scream about price long enough, salespeople will often come up with a lower price. Salespeople in our industry must stop caving in or contractors will forever put them to the pricing test.

When customers and prospects strongly react to a quoted price, it is usually called the "flinch.” The "flinch” is a predictable reaction that most salespeople have seen and heard numerous times. I believe that any customer response that is predictable is particularly important to learn how to respond to. After all, salespeople will hear it time and time again.

Action Plan: I recommend that the salesperson first recognize the flinch for what it is: a deceptive tactic intended to motivate salespeople to lower their prices if they have pricing flexibility. Salespeople must intellectually understand that the flinch is just part of the negotiating game. Hundreds of seminar programs are presented throughout the country every year that teach contractors how to get a lower price from subs and suppliers alike.

Here’s a salesperson response that I teach: "Wow, I’m really blown away by your reaction. We spend a lot of time and effort at our company trying to stay on top of the market. We are always getting copies of our competitor’s quotes and invoices, and our prices always seem to be in line. We belong to one of the largest buying groups in the nation, so we believe we buy competitively. Could you perhaps give me some more information? Our goal is to offer our customers the best value in this market, and that doesn’t stop at competitive prices; we work equally hard on our service and quality.”

In most cases, contractors simply want to be assured that they are not leaving any money on the table.

In my Gross Margin book, I identified 26 factors affecting gross margin; buying better was one and raising prices was another, but there are 24 additional factors that managers and salespeople must be intimately aware of for any company to optimize its gross margin. Make sure that both your managers and your salespeople understand how to take advantage of each factor that affects your company’s gross margin.

Bill Lee is a contributing editor with more than 39 years of experience in the construction supply industry.