4.6 Tools: Profit-Leverage Effect

One way to convince top management, and others in the firm, that logistics has a huge impact on the company's financial performance is to show them the numbers. In fact, a common saying at a leader in the semiconductor industry is, "If you don't have the numbers, it's just your opinion." Demonstrating the profit-leverage effect of logistics gives you powerful numbers. To preview the logic—and mechanics—of the profit-leverage effect, watch the following video:

The Profit-Leverage EffectTranslates the cost savings in logistics to the sales equivalent required to have the same profit impact. translates the cost savings in logistics to the sales equivalent required to have the same profit impact. A dollar saved in logistics almost always has a greater impact on profit than a dollar increase in sales. Why? Only a small portion of each sales dollar makes it to the bottom line. The rest is spent on the costs of doing business—e.g., cost of goods sold, transportation, inventory carrying, warehousing, marketing, and administrative costs. These costs must be deducted from each sales dollar to determine its contribution to operating profitA company’s revenue, less total operating costs. Also known as earnings before interest and taxes (EBIT). —our earnings before interest and taxes. Table 4-5 shows how this all works out on the income statement for Eco Distributors, an industrial distributor.

Let's say that you are starting an internship at this company, Eco Distributors. Your manager asks you to compare the impact of logistics savings to the impact of a sales increase in terms of contribution to profits. Naturally, you turn to the profit-leverage effect. Let's walk through the analysis:

Eco's operating profit (also known as earnings before interest and taxes or EBIT)—are $1.19 billion, on sales of $9.91 billion, for an operating profit percentage of 12.0% ($1.19/$9.91). For every dollar that the company sells, $.12 goes to operating profit. By contrast, every dollar of reduced logistics expenses goes straight to operating profit. Thus, a dollar saved in logistics is comparable to $8.33 in new sales (1/.12=8.33). Sales impact and contribution to profits is something that management understands.

Let's take a look at a specific example: If you were able to reduce the inventory carrying costs by 20%—from $288.0 million to $230.4 million—for a savings of $49.6 million, what is the equivalent sales you would need to generate to have the same profit impact? Answer: $413.2 million (i.e., 49.6 /.12 or 49.6 * 8.33). When the savings impact is explained this way, it gets top management's attention. You need to be careful to position this as the "equivalent impact" versus the "same as." It is NOT the same as selling $413.2 million more of product because selling more helps you gain market share, visibility, and growth. If you want to review how the profit-leverage effect works, watch the following video tutorial:

You can use the analysis in Table 4-6 to explain to your boss what the sales equivalent impact is for either different operating profit percentages or various amounts of logistics savings. For example, if your operating profit margin were 20%, you would need to sell $2.5 billion additional product to have the same contribution as saving $500 million in logistics. At 5% operating marginThe company’s operating profit divided by revenue, represented as a percentage. , you would need to sell an astounding $10 billion in product. The bottom line: the lower the operating margin, the greater the impact of logistics costs. In other words, the more important it is to manage logistics costs carefully. Companies in lower-profit industries should be more determined to reduce logistics costs, as they have less profit to spare.