Sales

Corporate operating efficiency begins with sales. A banking adage that I learned at the beginning of my career is this: “No one ever went out of business because they had too many sales.” Sales are the life blood of a business, the first key to corporate operating efficiency, and are effectively simplified in the V-Formula. That's because sales, like all Six Variables, can be expanded upon. An expanded formula for sales might look like this:

The V-Formula is a universal simplification that can be easily expanded. Given the above example, we could eliminate the sales variable altogether, replacing the single variable with the three components that comprise sales above. As we will see in this chapter, each of the Six Variables can be likewise expanded, which would result in a far longer, more complex formula. That said, the math would still be basic middle school math, which is a good thing from the vantage point of most entrepreneurs, since most of us never set out to be math wizards.

Behind the three variables comprising sales is one more: The number of different products you sell. In theory, the bigger your product line, the more customers you might be able to get and the greater the number of products an average customer might buy. You may also be able to charge a higher price for the convenience of having so many products.

Of course, in some cases, reality can be different. For instance, if you are a restaurant operator, more products will require a larger menu. Larger menus increase operating complexity, inventory needs, and likely raise the level of food waste.

In 1988, Wendy's, the nation's third largest fast-food hamburger chain, rolled out its Superbar, which was an expanded salad bar that included salad, fruit, Mexican fare, and even pasta. The idea was to raise customer counts through an expanded product offering. Franchisees were expected to shell out dollars to install the Superbars, which took up space that reduced dining area seating capacity. The effort at product offering expansion turned out to be an operational and gastronomic train wreck. Operators struggled with the elevated labor needs to manage the Superbar. Food costs, which are centered in portion management, were harder to control. So was food waste, which increased due to the need to constantly refresh food bar offerings. In this process, the chain saw its well-earned reputation for quality suffer. Ultimately, this impacted overall same-store sales, operating profitability, and the company's share price. In 1998, after a decade of struggle, the company pulled the Superbars and successfully turned to menu simplification.

The inspiration behind restaurant menu expansion is typically to limit the “veto vote.” Basically, the theory is that broad menu offerings will reduce the possibility that one member of a group—the family on vacation, for example—will express dislike for the menu and compel the group to look elsewhere, thereby losing several sales. But the lesson from Wendy's product expansion efforts is that sometimes it's better not to spend precious money and resources chasing every conceivable sale. Many restaurant chains have successfully implemented product strategies that entail limited offerings. McDonald's and Domino's began that way, and Chick-fil-A and In-N-Out Burger, with four members of the elite 2021 Forbes 400 list of wealthiest Americans among them, are two current examples of restaurant chains that successfully adhere to strategies grounded in limited menu offerings.

Operating Profit Margin

The second corporate efficiency variable is operating profit margin. Part of operating profit margin is simply impacted by the first component of the sales variable, which is product price. Assuming all else equal, if product prices are raised, then the corporate profit margin will go up. In reality, most companies in our competitive economy find they have limited pricing power. But you can see corporate efforts to earn pricing power everywhere. Branding is a clear example. When Daymond John created FUBU, he created a brand that people wanted to own, believing it to be more valuable. The sleek, appealing designs offered by Apple have long made its products aspirational, enabling comparatively higher pricing and elevated profit margins. Likewise, retailers often have private label merchandise affixed with their logos to elevate pricing power through branding and the appearance of scarcity (you can't find the exact same merchandise anywhere else). Unquestionably, aspirational luxury goods makers have invested a great deal in elevating brand awareness that confers pricing power.

Most business efforts to elevate profit margins involve cost control. If you are selling a retail or manufactured product, you might first look at managing your cost of goods sold. For many companies, this is their single largest cost. Walmart, the world's single largest retail chain, with annual revenues exceeding $500 billion annually as of January 2020, operates on notoriously thin margins. Between their fiscal years ending January 31, 2017, and January 31, 2020, gross profit margins (this is simply equal to [sales – cost of goods sold] ÷ sales) approximated 25%. No doubt, a great deal of effort is expended by the company to reduce its cost of goods sold and thereby elevate its gross profit margins. The sum of Walmart's operating and general and administrative costs amounted to about 21% of sales, or less than a third of their cost of goods sold. Doubtless, the company had initiatives in place to manage these costs also. That would be natural because their net income margin (reported net income divided into sales) averaged below 2% between 2017 and 2020. This kind of statistic makes Walmart a poster child for high volume, low margin companies. With profit margins this low, if you think you are getting a good deal at Walmart, you generally are.

As we discussed earlier in Chapter 4, operating profit margin is simply EBITDAR as a percentage of sales. However, in keeping with the thought that V-Formula variables are each expandable to elevate detail, a high-level formula for operating profit margin for Walmart might look like this:

Consistent with our financial approach, within the definition of EBITDAR (earnings before interest, taxes, depreciation, and rents), non-cash accounting conventions like depreciation and executive stock compensation are excluded from the formula. Also, lease costs for assets that might otherwise have been purchased are frequently included in operating expenses. I remove these costs as I try to make a more accurate assessment of the percentage of a company funded by OPM.

However, it should be clear by now that you can make this operating profit formula as long as you wish. You can break out specific goods costs or specific operating and general and administrative expenses. You might choose to do this to note the large costs that bear the most attention. By making single variable formulas for sales or operating profit margin into multiple variables, the simplified universal business model that is the V-Formula becomes far more tailored.

Business Investment

Asset (or business investment) efficiency is simply the notion of working to make your business investment as low as possible. All else equal, the less money tied up in business investment, the better. If you are operating the restaurant in our case study, you might attempt to see if you can construct the restaurant for less. I have helped finance thousands of restaurant properties and have occasionally seen companies desiring to build expensive monuments to gastronomy when smaller, more efficient facilities will do. Overbuilding requires little talent. Rather, the talent lies in crafting prudent construction budgets that deliver well-built facilities looking like you spent more than they cost. Or you might see if you can rent another property cheaply enough to represent an effective price discount over the cost of new construction. In such a case, you might even see if your landlord would pay for most or all the necessary conversion costs.

While the business investment of restaurant companies tends to be dominated by real estate, furniture, fixtures, and equipment costs, other business models entail significant investments in working capital assets, which include accounts receivable, inventory, and prepaid and deferred costs. This is especially so for manufacturing companies like FUBU or Apple, which tend to have every type of working capital asset imaginable. Retailers like Walmart will likewise have lots of dollars invested in inventory, but tend to have little in the way of accounts receivable; their customers pay by cash or credit card, which means that retailers tend to experience minimal delay between the time they sell their merchandise and the time they are paid for it.

What follows is a basic formula for the business investment V-Formula variable. As with the sales and operating profit margin variables, you can expand this variable to include the “hard asset” variables as well as a myriad of “working capital” variables that collectively comprise business investment. In this way, a universal business variable (business investment) can be custom-tailored to your business.

In our global economy, supply chain management has become a specialization and is at the heart of business efforts to limit their amount of working capital by speeding up the cash flow cycle. (You may recall Daymond John's initial onerous 240-day revenue cycle.) Inventory can be maintained at low levels through restocking strategies that entail inventory that is delivered “just in time.” Terms of customer accounts receivable can be shortened. Requirements for the prepayment of inventory or services can be limited. Vendor accounts payable terms can be lengthened. Customer deposits can be requested on orders. Indeed, there are a lot of working capital levers that can be addressed. Not surprisingly, given the increased level of attention to working capital demands, your efforts to reduce working capital will conflict with similar incentives on the parts of your suppliers and the businesses you sell to.

Supply chain management and a global economy have contributed to advances in business model efficiency. Perhaps the biggest of these is for companies to elect “asset-light” operating models. Think of Apple, where merchandise labels note that devices are “designed by Apple in California,” but made globally through a sophisticated supplier network. As a result, Apple has fewer requirements for real estate, furniture, fixtures, and equipment, which lowers their business investment needs and trades off high levels of associated fixed operating costs for variable production costs. Likewise, clothing manufacturers such as FUBU have the potential to limit their expenditures to the design elements of their business, outsourcing production and distribution. Through such efforts, the aim is to achieve a business model requiring less cash to create, resulting in less OPM and less YOM while delivering a high level of scalability and the potential for elevated equity returns and wealth creation.

Operating leverage is the ability to materially grow sales without similar added investments in hard assets. Operating leverage tends to be a common characteristic of companies capable of high levels of EMVA creation. Still, even with such companies, working capital business investment requirements will tend to rise commensurately with sales. For working capital intensive businesses, the downside of sales growth is a loss of cash that might otherwise have been used for other investments or contemplated investor cash distributions. How much can sales grow before you need additional equity infusion to support working capital? The answer is approximately the same sales growth as your current rate of after-tax current equity returns, which is also what is called your “sustainable growth rate.” Here, it's worth noting that added working capital business investment can be driven by either real or inflationary sales growth, which serves as a reminder of the destructive impacts of inflation.

Early on in my banking career, I recall looking at a successful Latin American retailer based in a country having a very high rate of inflation at the time. The resultant working capital growth left the company in a cash trap requiring continued inflation-driven business investment producing no real added value. For working capital intensive companies, added business investment will accompany sales growth, whether it is real of inflationary.

Notably absent from the computation of business investment are research and development (R&D) costs, which are central to technology-centric companies. Without question, R&D activities are absolutely an investment in the future, but they are typically not shown as balance sheet assets. They are instead expensed, impacting operating profit margins and operating efficiency, as opposed to business investment and asset efficiency. This characterization can potentially serve to understate equity rates of return, assuming you believe your R&D costs to be investments having real long-term value that will translate into future revenues.

In a nutshell, that is what business investment is: Assets essential to revenue creation that are funded by OPM and equity. Therefore, in determining your V-Formula, you might consider the inclusion of R&D costs as a business investment while removing them from operating expenses. Or you can take a more conservative approach by including R&D costs as operating expenditures, which will serve to compress your operating profit margin and lessen calculated equity returns.

Choosing how to best incorporate R&D costs into your current equity return analysis mirrors accounting imperfection. On the one hand, GAAP demands that R&D costs be expensed when they are made. On the other hand, when a company having made such R&D investments is acquired by another company, it is acceptable to capitalize the proven value of trademarks and patents into business investment. In other words, the accounting profession permits capitalization, but only in the context of an acquisition after the R&D expenses have demonstrated their long-term value.