Guidelines for Acceptable Direct Selling Expenses (1,202 words)

Direct Selling Expenses -

What Are Acceptable Guidelines?

By Stephen Lett

An important ratio to manage on the income statement is your selling-expense-to-sales ratio.

our cost-of-goods ratio is probably imbedded in your head. But are you as familiar with the other key ratio on your profit and loss statement: the direct selling-expense-to-sales ratio? If not, you should be.

In this article, I will discuss what is an acceptable guideline for a consumer catalog company and for a business-to-business cataloger. I will also examine what percentage of the total each of the line items in selling expenses should be. Last, I will determine the effect on the selling expense-to-sales ratio when more (or less) prospecting is done. Aggressive prospecting can spell financial disaster! I will show you why.

It is important to organize your income statement so that your direct selling expenses are grouped together and subtotaled. Selling expenses should neither be grouped with your operating expenses nor with your administrative expenses. Again, these line item expenses need to be separated and exposed on your income statement so that you can better manage this ratio.

Direct Selling expenses are all of the costs associated with the production, printing and mailing of your catalog. Internal payroll and labor costs are not generally included here unless you produce the catalog in-house. Then, the direct cost to produce the catalog should be included in your Catalog Creative and Production costs.

The following expenses should be included in your selling expense breakdown:

•Catalog Creative and Production (outside design firm)

•Paper and Printing

•Bind-in Order Form

•Postage

•Outside List Rental Expenses

•Merge/Purge Expenses

•Ink-Jet Addressing and Mailing Fees

•Space Ads (if any)

•Alternate Media (if any)

The selling-expense-to-sales ratio is a critical factor contributing to the profitability of any catalog company. If the ratio is too high, a cataloger will lose money, guaranteed! If the ratio is too low, the cataloger is probably under prospecting. A high ratio is the exact reason why a start-up cataloger cannot be profitable. Too much money has to be spent renting names and developing a housefile of proven mail order catalog buyers. Start-ups will spend more than 50 percent out of every dollar of sales to acquire a new buyer. There is a cost to growing a housefile. Most catalogers cannot prospect above the incremental break-even point defined as: net sales less cost-of-goods less direct selling expenses less direct order processing costs.

Incremental Break Even Formula:

Net Sales

- Cost of Goods

- Direct Selling Expenses

- Direct Ordering Processing Costs

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Incremental Break Even

Catalogers who try to grow too fast increase their selling expense-to-sales ratio, which makes their bottom line suffer. So what is an acceptable ratio for a consumer and for a business-to-business cataloger? For a consumer catalog company, the selling expense-to-sales ratio should be between 25 percent and 30 percent of net sales. For a business-to-business cataloger, this critical ratio should range from 15 percent to 20 percent of net sales. Let's take a look at what makes up these ratios.

First, examine which expenses should be line items, and what percentage of total expenses they should be. If any one of these percentages is out of line, this could be the reason why your selling expense-to-sales ratio is too high overall. Refer to Chart A on page 39.

Note that the line item expenses are included in selling expenses. There is a column for a consumer catalog company and a separate column for a business-to-business catalog firm. I have based these ratio comparisons on a collection of the income statements from companies with annual sales ranging from $2 million to $30 million.

Guideline: The higher your gross margin percentage, the higher your selling expense-to-sales ratio. Companies that enjoy a high gross margin, i.e., greater than 60 or 70 percent, generally have a higher selling expense-to-sales ratio. The opposite is also true. If you are in a highly competitive market like sporting goods, electronics or other brand name products with a gross margin of less than 40 percent, your selling expenses as a percentage of your sales will be low. Why? In a highly competitive marketplace where prices are easier to compare, response rates are generally higher. This increases demand, which helps to reduce selling expense-to-sales ratios. Average order sizes will tend to be higher, too. The typical selling expense-to-sales ratio for a consumer catalog company with annual sales of less than $20 million and a gross margin of 50 percent will be approximately 30 percent of net sales. A cataloger with a selling expense-to-sales ratio much above 30 percent is probably overprospecting in relation to the size of the housefile. If you overprospect, the red ink will flow!

Now, let's take a look at the percentage of the total direct selling expenses each of the line item expenses comprise. In other words, what percentage should postage, paper and printing represent to total selling expenses? As you can see from Chart C (page 43), paper/printing and postage make up most of the selling expenses. They are about equal. The percent breakdown of your selling expenses should be similar to Chart C.

The key ratios that need to be managed are in the direct selling expense category. There can be variations by line item as long as the total selling expense-to-sales ratio does not exceed your overall goal for this category. This is only a guide. Your actual percentage will vary.

Last, let's examine the relationship of the housefile to prospecting. If you want to remain profitable, it is important to maintain a balance between mailings to the housefile vs. mailings to prospects. Startups or companies with small housefiles will see lots of red ink. This is based on simple arithmetic. A typical response rate to a housefile is 3.5 percent to 4.5 percent compared to 1 percent to 1.5 percent (or more) from outside rented names. Mailing to more rented names will dilute the overall response rate from the housefile, which will most likely result in a bottom line loss. The first column of Chart B (page 40) represents the balance between mailing to the housefile and to outside rented names. As you can see, this balance results in a positive contribution to profit and overhead. The second column shows what happens when the amount of prospecting is increased by 30 percent. The next column represents an increase of 50 percent over the base amount. Finally, the last column calls for a 100 percent increase in prospecting, and as you can see, the contribution to profit and overhead is negative. Keep in mind that this example does not consider the lifetime value of the names acquired. The more prospecting that is done, the less contribution there will be. Unless a company is well financed, less contribution will affect profitability and cash flow.

Be sure to let your housefile support your growth. It is the housefile that pays the salaries and other operating expenses. Pay attention to these important ratio guidelines and watch your profits soar!

Stephen R. Lett is president of Lett Direct Inc., a catalog consulting firm specializing in marketing, circulation planning, forecasting and analysis. He can be reached at (317) 844-8228 or by e-mail at slett@lettdirect.com.