Our team was recently modeling the future growth of one of our clients, and we happened to be working closely with a skilled financial analyst at our client’s location. When we got back his first growth model, he had applied a multi-year compound annual growth rate (CAGR) for his company to five future years. Perfect. That growth rate would be readily accepted by an acquirer, since it is based on an historical record.
Next, taking a conservative position, he maintained the earnings before interest, taxes, depreciation, and amortization (EBITDA) as a percent of sales for the five future years.
Readers of this column know that the EBITDA as a percent of sales is a crucial key performa that expresses what percent of sales become earnings.
Next, however, the analyst created what we viewed as an error. As the sales climbed, he modeled a corresponding symmetrical increase in OPEX as a percent of sales (operating expenses), essentially coupling sales and OPEX percent increases. This maintained the EBITDA percentage for the future years of the model. But was it correct to assume that OPEX would rise symmetrically with sales revenue? Moreover, if the OPEX did not climb at the same rate of sales, we knew that EBITDA as a percent of sales would improve, because a dollar saved in OPEX adds a dollar to EBITDA.
Invariably, as your sales rise, there will be some higher OPEX/fixed costs that are associated with it, e.g. back-office support, expanded real estate for inventory, new rolling stock, etc. That’s both unavoidable and healthy for your business. Why starve your operations of resources?
But OPEX as percent of sales (another closely scrutinized KPI) does not have to rise at the same rate as sales. In fact, it’s likely that:
1. You already have elasticity in your workforce and infrastructure to handle growth; your staff can accommodate a rise in sales without proportionately adding OPEX.
2. Within OPEX, you have fixed and variable expenses. Fixed expenses like rent, will typically go up with inflationary increases. Variable expenses like sales commissions will follow sales increases more closely. This alone can slow (or halt) the coupling of sales and OPEX growth rate. By not laying on OPEX as your sales grow, your EBITDA dollars grow and your EBITDA as a percent of sales improves. If you increase OPEX in anticipation of sales growth, or add it faster than sales growth, the opposite will happen.
3. Well-run businesses often get more efficient as they grow, not less. So, it’s likely that you can decouple sales and OPEX growth, so they don’t increase at the same rate.
How can you ensure OPEX growth control? As well-run businesses grow, we have seen leadership take a more “dashboard-driven” approach to managing the operation.
Popular tools like Microsoft Excel with Power BI, Tableau, Zoho, and Google Sheets can readily take data and convert it to dynamic graphs for review. Increasingly, AI is being employed with these systems to fuel accurate analytics as well. Consider starting and ending your day with a KPI dashboard that shows your sales, OPEX, OPEX percent, GP dollars, gross profit margin, EBITDA dollars, and EBITDA percentage.
In revising our client’s growth model, we actually reduced OPEX as a percent of sales over time, increasing efficiency and productivity. In Excel, we could see EBITDA as a percent of sales improve, and EBITDA dollars grow, as the OPEX percent decreased. Probably the only “flaw” in the model was that a lack of OPEX discipline would punch a hole in it.
But in the financial modeling we have done for other clients during the run-up and run-down of lumber prices, these companies universally did not increase OPEX as they enjoyed more gross profit dollars, and a higher EBITDA, from higher commodity prices. We think they can do the same when the higher gross profit dollars come from increased sales across all product categories.
