July/August 2004

Profitability Planning:
Why Bother?

By Dr. Albert D. Bates

A large group of NBMDA members don’t ever develop a financial plan. They simply buy things and sell things and hope that it all works out for the best. Another significant group of firms follows a very specific three-step approach:

• Develop a detailed plan, often using outmoded procedures.
• Lock the plan into the desk drawer for fear someone will see it.
• Pull the plan out next year and repeat the process.

Only a final, very small, group of firms actually plans proficiently. They plan for profitability and they use that plan as a basis for control during the year. While this group is not assured of success, research studies suggest that firms that engage in proper financial planning enjoy slightly higher sales and dramatically higher profits than those that do not.

The problem is that most firms don’t have a precise understanding of how planning should be done or what the goals should be in the planning process. This report will address those issues by looking at two specific factors:

• Realistic Profit Goals—A review of the goals that NBMDA members should strive for in order to produce a satisfactory return on investment.
• Planning for Profit—An identification of how the profit planning process might be employed by the typical NBMDA member to reach the profit goal.

Realistic Profit Goals

In setting a profit goal, the first issue is to decide which measure of profitability to use in the planning process. There are numerous ways to look at profitability, each with its own strengths and weaknesses. By far the best measure of overall company performance is Return on Assets (ROA) because it measures the return on the totality of all of the investment in the business.

Return on assets is simply the profit the firm produces during the year (before taxes) expressed as a percentage of the total asset investment required to generate that profit. Total assets is the total amount of money invested in the business, regardless of who made the investment.

In setting a target for ROA, it is useful to start with the three reasons why the firm needs to generate a profit to begin with—providing a risk return, supporting growth and offsetting inflation.

The profit level required by a specific NBMDA member depends upon the unique combination of these factors. Generally, firms should strive for at least a ten percent ROA. For the top tier of firms a legitimate goal is twenty percent.

Planning For Profit

The primary reason firms develop a plan and then forget about it, is that in their experience planning doesn’t have any impact. The real problem is that most firms plan improperly so that even if they follow the plan closely, they don’t produce an impact. The plan must lead to better results. The key to that is to use what is commonly called profit-based planning.

Profit-based planning reverses the entire budgeting process. It suggests that as the first order of planning each year the firm should set a realistic profit objective. Realistic is the key word in the equation. It is what the firm can reasonably expect to achieve in the future based upon past performance.

The process behind profit-based planning is extremely simple, almost to the point of being rudimentary. Behind this simplicity lies an extremely powerful planning philosophy, however. Namely, that without appropriate planning, profits are likely to always be inadequate. Without a goal, you will always be headed nowhere.

Exhibit One demonstrates how return on assets is used in profit-based planning for the typical NBMDA member. The process involves six steps. The left side of Exhibit One has the results already entered for the typical NBMDA member. The right side has space for you to enter numbers for your firm. It is a critical process that should be approached very seriously.

• Step One--Enter actual pre-tax profits for the latest complete fiscal year. For the typical NBMDA member this is $840,000.
• Step Two--Enter total assets at the end of the year. Again, using the number for the typical firm, $10,000,000.
• Step Three--Calculate return on assets. This is simply profit divided by total assets, expressed as a percent of assets, or 8.4%.
• Step Four--Set an improvement goal for return on assets. A goal in the range of two to three points is strongly suggested. This forces the firm to do better, but doesn’t produce an unattainable one-year improvement. In the exhibit an improvement factor of 2.6 percentage points has been used.
• Step Five--Add the old ROA figure and the improvement figure to obtain a new ROA target, or 11.0%. This is well below the twenty percent figure that was suggested as an ultimate goal. However, it starts the firm moving toward that profit level.
• Step Six--Take the total asset figure from step two and multiply times the new ROA target from step five. This produces a realistic profit target of $1,100,000 for the firm for next year.

Clearly, this process is extremely simple. The calculations can be done in two or three minutes. Because of its simplicity many firms avoid the entire process, thinking that life just isn’t that easy.

Of course, achieving financial success probably will not be easy. However, profit-based planning does one absolutely essential thing—it identifies how much profit the firm really ought to produce. Failure to establish this goal is a fundamental reason why the typical firm continues to have sub-standard profit performance. It is a problem that can be overcome with proper planning.

Moving Forward

Most firms never plan, so profits simply end up being whatever is left over at the end of the year. They don’t plan because they don’t think they should bother. However, those firms that engage in profit-first planning inevitably produce substantially higher profits than those that do not. It is a profit opportunity that is open to all firms. It is an opportunity that should not be passed up.

About the Author:
Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2004 Profit Planning Group. NBMDA has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited.

A Managerial Sidebar on
Return on Assets Versus Return on Net Worth

Return on assets (ROA) is the best ratio available to management for measuring the economic viability of the firm. That is, it does the best job of determining whether or not the firm has an economic model that justifies its continued existence.

In contrast, return on net worth (often called return on equity) does the best job of measuring the return on the owner’s investment. RONW is an extremely valuable tool. Many executives prefer RONW as it answers the question of “what’s in it for the owners?”

However, firms that produce a high RONW, but a low ROA are doing so only by employing a high level of financial leverage. Ultimately, such firms face major financial challenges, particularly in times of economic difficulty. Firms should continue to employ RONW, but they should make ROA their major focus in evaluating past results and planning for the future.

For the typical NBMDA member the two ratios are:

A return on assets below 5% is a cause for serious concern. Literally, the company is not producing an adequate return to ensure its survival. A return between 5 and 10% is adequate. When the return reaches the 10 to 20% range, the firm is producing strong results. Anything above 20% is outstanding.

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