Most people have a mistaken belief that my services are all about making component manufacturing more efficient. Actually, more than half my time during a consultation is taken up reviewing things like management practices and the sales process. Fact is, sales—correction, healthy sales—is the most important aspect of any business or services. So, it is critical that the management team and the sales team have a proper perspective of what healthy sales entail.
The title of this article is not a joke. Too many component manufacturing companies in our industry are screwing up their markets with self-inflicted wounds, and they fail to understand the causes. Eventually, their sales team will lead them to bankruptcy.
Consider the graphic below showing how sales commissions affect a $1 million sale at various gross margin (GM) levels. In this case, GM covers the direct cost of material plus labor as a percentage of the sales price. “True GM” describes gross margin after the cost of the salesperson’s commission—something that also ought to be considered a direct cost. Thus, a $1 million sale may yields $350,000 on a 35% GM, but if the salesperson gets a 2% commission, that takes $20,000 out of the proceeds. That makes the True GM $330,000, or 33% of the sale price.
The worst thing you can do is pay salespeople a flat percentage of the total sales price without regard to gross margins. This is a terrible practice; stop it immediately. Why should a salesperson make a commission when the company does not earn enough of a gross margin? *
To a salesperson being paid a commission on the total sale price, the price is the only thing that counts to garner them more sales. A zero GM versus 40% GM project does not matter to them because any sale is better than no sale. Never mind that the low-margin projects are detrimental to the company, what matters to the salesperson is the sale to garner a paycheck. This problem gets worse when reps have control over the sales price because it means they can discount the quotes at will. That is playing with a raging future bankruptcy fire. I have yet to hear a salesperson complain that pricing or cost of manufacturing is too low.
Most salespeople are set up to be in competition with other salespeople for the company’s resources. A classic example is when the schedule is four weeks or more, but the customer needs it sooner. The first thing a lot of salespeople will do is try to push out any other project to make room for their customer (as long it does not affect one of his/her other sales). They’ll do this even if it may screw over the other salespeople. Why do they do this? Because they are being paid monthly on the total sales being processed each month. They have no incentive whatsoever to be in cooperation with other salespeople. When sales are at their peak, all any salesperson wants is more, more, more! More production, design, and delivery capacity. In fact, they are not working for the best interest of the company, they are working for their customers and at times to the detriment of the company.
“Oh Todd,” you might reply, “we can make up for the lost GM though higher volume.” Yeah, right. Let’s look at the spreadsheet again. A million-dollar sale of roof trusses at a 35% GM generates a True GM of 33% after the sales commission. Now, let’s say wrong-headed bargaining and competitive pressure cuts the True GM to 25%. At that rate, you’d need to generate $1.43 million in sales to produce the same number of margin dollars as you did if you had sold a $1 million project at 35%. That means 43% more manufacturing, design, and delivery capacity to make up for lower GM projects. How many of you are doing this and are also complaining about the lack of labor? It sounds to me like you are shooting yourself in the foot and then complaining it hurts a lot.
Here’s a novel idea: Sell less volume at a higher margin, which means less manufacturing needs, design, and delivery capacity, and yet make more net profit. Management must manage the balance between proper margins versus less volume, which will always hurt the salesperson’s commission totals.
Not all projects should have the same priority for processing. Low-margin projects should only be used for spare capacity and be the lowest priority for any manufacturer. To process and prioritize every project with the same urgency is very short-sighted. Every company has limited resources, and it is management’s responsibility, not the salesperson’s, to define how they are being utilized to maximize profitability. Salespeople should never control the scheduling of manufacturing or delivery.
Track the actual direct cost for each project and apply it to each order for activity-based cost accounting. By actual cost, what I mean is actual material and the person-hours of labor in the manufacturing, not estimated. If your company is not tracking the actual labor in the manufacturing then you are not implementing proper time standards to maximize production capacities. For more, see Why LBM Needs to Hire Industrial Engineers.
Another direct cost that too many of you are overlooking is the delivery cost. “Oh Todd, we figure the GM will take care of the delivery cost,” I often hear. How about that discounted garage package taking all day to deliver with the low margin? Was there enough GM to actually cover that delivery cost? And how much GM was left over to cover the company’s gross margin for the day? Again the excuse often given is sales volume, which somehow the math never proves to be true.
Here’s one last point to be made about sales and margins: The building economy has been very good recently, and it’s expected to be very good this year. This means your net profits for component manufacturing today should be above 10%. If you’re not doing that well in this era of strong sales, maybe your sales team is not properly motivated to make the company produce healthy sales.
To sum up...
- Sales commission should be based on GM, not the total sales price.
- Track and apply the actual, not the estimated, direct cost of manufacturing. This includes the delivery cost.
- Projects generating low gross margins should be used only when there's spare capacity, and they should get lower priority on the production line.
All the practices that I have been stating in these articles are being used every day by the most profitable companies. Changing to new practices can at times be difficult but can and should be managed. Get professional advice, create a plan, and execute it with drop-dead dates.
* As for what GM is correct for you, that’s a whole different topic. For more, read How a Truck Repairman Can Help You Run a Better Truss or Components Plant to see about establishing the margin based on production time, not a cost markup.
If your group is thinking of improving or starting a new component operation, give TDC a call. TDC has proven time and again that we are the go-to experts at reducing cost and improving productivity in all departments of wood truss and wall panel manufacturing. TDC does not receive any referral fees from any equipment or plate vendors.
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