(Note: the first part of this report by Dr. Al Bates, Profit Planning Group, was presented in last month's Snips.)

Before suggesting solutions (to the challenge of rising wages), it is useful to understand exactly how small of a change is required to completely offset the wage pressures. Exhibit 1 does this by examining results for the typical NHRAW member. The current column simply reflects the results produced by the typical firm in the latest member profitability survey.

The wage pressure column reflects what has happened for a number of firms over the last couple of years. Starting at the top, assume that sales have grown by 5%. The sales were attained on the same gross margin percentage, resulting in exactly a 5% increase in gross margin dollars.

Most important is expense growth. For payroll expense, which is the major expense component for NHRAW members, the assumption is a 6% increase. This is about what actually happened between 1997 and 1999. Finally, other expenses are assumed to grow at the same rate as sales, something that also reflects recent experience.

The impact of this 1% differential between sales growth and payroll growth is much more significant than might first appear. It creates a measurable expense problem and drives down profits as a percent of sales. The firm is far from mortally wounded, but is stagnating.

The sales enhancement column flip-flops the relationship between sales and expenses. In this instance sales growth is set at 7%, again assuming the same gross margin percentage. Payroll once again grows at 6% and other expenses grow at the 5% rate used previously.

This model could have been constructed so that sales growth remained at 5% and some method was found to drive the effective wage growth down to 4%. However, the underlying theme of this discussion is that such cost-reduction efforts have reached a point of diminishing returns and that a sales focus is required.

Control expenses

The difference in profitability in the sales enhancement column is notable. With expenses under control, profits increase sharply. All of this is attributable to a 2% differential in sales growth, from 1% below the payroll growth rate to 1% above. The point of Exhibit 1 is simply to suggest the modest improvements that are needed. The challenge still remains in making such growth a reality.

The traditional cost reduction model focuses entirely on the cost of performing any function in the firm. The cost is dependent upon three factors: the payroll cost per hour; the level of productivity in performing the function; and the number of times the function must be performed.

As a simple example, the cost of processing invoices depends upon the wage rate of the employees processing the invoices, the number of invoices processed per hour and the number of invoices that must be processed. Changing any one of the three factors (reducing labor costs, enhancing productivity, or decreasing workload) should be equally desirable from a cost perspective. All three are beset with problems, though.

Wage rates are rising. While manufacturers can move facilities off-shore to take advantage of lower wages, distribution firms cannot. Customers in Cleveland need service in Cleveland.

Productivity has been greatly enhanced in distribution in recent years with new technology. The unfortunate reality, however, is that there is a point of diminishing returns on productivity. Additional improvements in pure productivity are becoming more difficult to achieve.

Lowering the workload imposes on customers. If fewer orders are going to be processed, customers must be disciplined to buy less often. Similarly, to lower the number of returns, it is necessary to force customers not to return things. In a competitive market, this is risky at best.