While many pro dealers have worked very hard in recent years to enhance the value they provide to customers, they often don't end up receiving quid pro quo for the effort. As a result, far too many LBM suppliers are now faced with an eroding gross margin that is no longer adequate to cover the increased cost of providing value-added services. Operationally, service levels have been increased, order cycles have been shortened, error rates have been lowered, and customer service has become a way of life. But at the same time, severe price pressures have mounted. In short, dealers have been forced to provide more services for less money.
From a strategic perspective, this means that the value proposition many pro dealers are providing to their customers does not work. Either customers do not fully appreciate the value they receive or the cost of providing that value is excessive. In both cases, for a LBM supply company to break free of the downward spiral, management must first measure the effectiveness of the company's value proposition and then undertake a path of improvement.
Value Added While enumerating the list of values that you provide to customers is an almost endless activity, measuring the value that customers place on those services actually is quite straightforward. It is simply gross margin, and it represents how much of a premium customers are willing to pay for the services they receive. However, calculating the cost of providing those services is much more difficult because most services are directly related to human activity—sales calls at customer locations, making deliveries, etc.
Consequently, a proxy for the cost of providing these services is total payroll—including salaries and all fringe benefits. Benefits encompass payroll taxes, health insurance, and retirement programs, but exclude items such as uniforms, travel, and company-provided laptop computers. Therefore, a dealer's value proposition can be measured by the Personnel Productivity Ratio (PPR), which simply is total payroll costs (including all fringe benefits) divided by total gross margin. (For dealers that have moved heavily into the sale of services, such as installation, this ratio should be derived very carefully, and the cost of labor hours sold should be included in the cost of goods sold rather than in payroll expense.) This ratio measures the cost of providing services as a proportion of the value received. Based on the results for the typical NLBMDA member gleaned from the association's annual “Cost of Doing Business Report,” the PPR is 61.1 percent. This means that for every $1 of gross margin the typical firm generates, 61.1 cents must be devoted to payroll and fringe benefits.
From both a strategic and a profitability standpoint, a percentage of 61.1 percent is too high—probably way too high.
Improving the PPR There are many misconceptions and arbitrary guidelines regarding the PPR. One of the most frequent is that the PPR should be less than 50 percent. This and other statements regarding the ratio are nothing more than well-intentioned myths.
The only thing that can be said with absolute certainty is that lower is better than higher. Fortunately, the NLBMDA “Cost of Doing Business Report” does provide a basis for targeting PPR improvements. It indicates that while the typical firm has a PPR of 61.1 percent, the PPR for the high-profit NLBMDA dealer is 55.5 percent. Hence, there is a clearly measurable improvement opportunity of 5.6 percentage points that a dealer can strive to achieve over time.
To close the gap and build a stronger profit base for your company, you should consider trying to lower the PPR by about one percentage point per year. For example, the second and third columns in Figure 1 reflect the impact on pre-tax profits that can be achieved in one year and in five years by lowering the PPR by one point per year. (For the purpose of illustrating only possible PPR improvements, sales, gross margin, and non-payroll expenses have been held constant in Figure 1, which would not happen in reality.)
As can be seen by this example, a slow and systematic PPR reduction can improve your firm's bottom line. While this does not produce dramatic improvements, it does help to rebuild a business so that its value proposition is working.
But as useful as the PPR is, it does have a major flaw. Namely, it can be improved by lowering payroll, increasing gross margin, or both. Consequently, it doesn't focus the firm on one thing that needs to be done to strengthen the value proposition; most firms need to focus concurrently on making both expense reductions and margin improvements.