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Money Matters continued ago most inventory control systems were run on index cards. Today, most firms have sophisticated inventoryman- agement systems. Increased sophistica- tion has not lead to better results for one reason. Firms continue to make the same mistakes at the same exact points in the business cycle over and over. This is not a criticism of management. Instead, it is an inevitable aspect of human behavior. However, improving profitability— nowor at any other point in time—must involve overcoming those normal behavioral tendencies. Management must overcome the pressures that lead to business as usual. Making the Future Better The remainder of Exhibit 1 examines how the firm could produce even more profit in 2011 by better managing the Critical Profit Variables (CPVs). These are the factors that have themost power to drive profit in the firm. The three most important are sales, gross margin and expenses. Every firm is already managing the CPVs as effectively as they can, of course. The reality is that in the recov- ery phase of the economic cycle, firms look at the CPVs in a very different light than they do in the down phase of the cycle. This change in perspective limits the profit potential associated with A Managerial Sidebar: Setting a Profit Goal Probably the oldest concept in all of financial plan- ning is that small changes in the Critical Profit Variables (CPVs) cause profit to increase. Despite the fact that the concept is ancient, it is often overlooked in a period of economic recovery. The following chart indicates how much dollar profit would be increased for the typical FEDA member if each of the following four items were increased by one percent. That is, if prices were increased by one per- cent, items were purchased at a cost that was one per- cent lower and the like. The figures provide some useful insights into how firms can use these small improvements to make profits even greater than they would be otherwise. 36 FEDA News & Views Area of One Percent Improvement Pricing Buying Net Sales Payroll Expense Percentage Increase Dollar Profits 47.7 % 37.5 % 10.2% 7.5% recovery. As markets stabilize following a sharp recession, two things inevitably occur. First, expenses demonstrate a relentless tendency to increase. More infrastruc- ture is needed, employees need wage increases to "catch up" and the like. Second,pricing challenges arise. This is because the excitement inherent in sales increases automatically reduces the attention paid to pricing that is essential for desired profit performance. It is important to note that these pres- sures have already been accounted for in the first column of numbers in the exhibit. That is, the exhibit assumes that human beings will continue to act as human beings.Not so much a failing as a reality of life. The remaining columns examine the impact of maintaining greater diligence in the face of the sheer relief that the recession has ended. The two areas of focus explored in the exhibit are pricing and employee compensation. In both areas,a 2 percent improvement factor is used. The 2 percent figure is not arbitrary. The better-performing firms across a wide range of industries tend to do about 2 percent better than the typical firm each year. The 2 percent differ- ences add up to a dramatic improve- ment in overall profitability. Pricing remains theAchilles heel of every recov- ery. As sales rise due to improving eco- nomic conditions, there is a natural ten- dency to want to recover sales volume at an even faster pace. This invariably leads to a diminished level of pricemon- itoring. In the Margin Control column in Exhibit 1, the firm generates 2 percent more gross margin dollars. The cost of goods remains constant, so the entire 2 percent increase is the result of improved pricing. The net effect is that profit increases by 25 percent. The Payroll Control column reflects the human tendency toward fairness. When sales growth returns, the pres- sures on payroll become enormous. Employees naturally want a share of the good times just as they shared in the pain of the down market. If the payroll increase can be moderated so that it is 2 percent less than might otherwise occur, profit would increase by 15 per- cent. Sharing is fine, controlled sharing is much better. The real payoff, of course, comes from doing both things simultaneously. The final column of numbers demon- strates how the firmwould look if both gross margin and payroll were con- trolledmore systematically. The 40 per- cent improvement changes the entire profit profile of the firm. Moving Forward After a brutal economic recession, there is a tendency to dramatically under perform compared to the poten- continued on page 41