Landing the big fish
How to decrease prices, sell big customers and keep the boat afloat
by Scott Benfield
In a recent visit with the Chief Procurement Officer (CPO) of a major manufacturing company, the conversation centered on how to get demonstrable savings out of indirect supplies. The annual budget was more than a billion dollars. The company had a long history of working on advanced supply chain initiatives including integrated supply and vendor-managed inventory agreements. However, after reviewing the managed inventory agreements, the CPO expressed concern that the “soft” savings touted by suppliers were overestimated and the hard savings were inaccurate given advances in technology and processes that could be performed in-house.
We were invited by the CPO to discuss a series of articles and research that we’d completed about the changes in distribution markets wrought by globalization and new knowledge on transaction economics. The CPO believed his company could take advantage of these events to significantly lower the price of his indirect supplies. From our perspective, he was correct. Our message for him and other large customers is that distributors, in the future, will need to get used to operating on thinner margins and with different suppliers to land the Big Fish. This will require substantial changes in relationships, procurement and managing the sales effort through Transaction Management.
Off-Brands and the Price Advantage
The first area that wholesale-distributors will need to address is foreign off-bands. Our research1 into the availability of foreign off-brands indicates they are growing in importance. A year ago, 20 percent of available inventory was what we termed off-brands, which are products made on foreign shores but at significantly lower price points than domestic brands. The average landed price differential of off-brands vs. domestic brands was 35 percent and the products were growing significantly.
Our further research shows
these are high-quality products. More than two-thirds of distributors believe off-brand product quality equals or exceeds domestic brand product quality. Figure 1 shows the responses of approximately 200 distribution executives who were asked to compare off-brand product quality vs. domestic brands. Today, we estimate that off-brands represent approximately 25 percent of available channel inventory, and are growing by 5 percent per year.
The question on the mind of the CPO was how does a major buyer engage its distributors to begin sourcing these products and, if necessary, help develop the process? Our response was not altogether positive. Domestic distributors have a variety of volume rebates, special pricing agreements (SPAs) and other mechanisms with domestic vendors. These loyalties, while costly in processing, have been used for years with increasing frequency by domestic vendors to combat off-brands. Breaking these loyalties would require a directive from the major buyer that it would consider purchasing off-brands. To be successful in this endeavor, our advice to the CPO was to make sure the distributor had demonstrated experience in off-brands including product testing and certification and proof of insurance for liability and recall claims. Beyond this, distributors should be able to pass on part of the landed cost differential on these products. Our research finds that distributors try to maintain the buy-side advantage as long as possible, and it takes approximately two years for lower prices to make their way into the marketplace.2
Large customer purchases of off-brands is not new. However, the speed and availability of quality products from around the world is growing and there is a rising expectation that domestic customers will request these items and expect an immediate buy-side incentive. Distributors caught in yesterday’s world of volume rebates, special pricing agreements and co-operative buying with domestic vendors will find that these channel supports are not competitive versus off-brands and their upfront price advantage. We believe these old-style channel supports will decrease and distributors that rely on them will be at a significant pricing disadvantage in the market.3 Also, other changes are coming in understanding Transaction Economics that will allow distributors to drop price and secure orders from the Big Fish.
The Fields Of Transaction Economics and Management
Several years ago, we began to move away from disciplines of Activity Costing, Activity Management and Customer Profitability. These disciplines had significant flaws, including excessive complexity and cost, poor correlation with operating profits and poorly tested implementation suggestions.4 Our knowledge shifted to transactions and transaction types and how they influenced profitability and can be used as strategic sales tools.
In essence, profitability in distribution has too often been driven by concentrating on margin dollars, sales or operating expenses. The problem with these measures is that, by themselves, they are incomplete, because they do not connect selling activities or transactions with their costs. Using transaction types, we developed Differential Costs by transaction type, which finds that the vast majority of a distributor’s profits are from two transaction types, namely stock (original orders) and direct shipments.
For the average distributor, 25 percent of transaction types lose 40 percent of the operating profits. What are these toxic transactions? They include counter sales, non-stock sales, back-orders and some stock transfers. These transactions are, on average, either very expensive to process or too small in generated margins to cover their processing costs. A distributor that balances out these transactions can take a lower price to market and pacify the low-price demands of large customers.
Consider a $100 million distribution firm with 23 percent gross margins ($23 million), 20 percent operating expenses ($20 million), and 3 percent of sales ($3 million) operating profit. Applying the rule of thumb that 25 percent of transactions lose 40 percent of the operating profits, the math finds that $25 million in sales and $5.75 million in gross margin dollars costs $7.75 million to serve. How’s that? If the total profits were $3 million and 40 percent of operating profit is destroyed by these transactions, then the operating profit would be $5 million if the transactions covered their cost. Hence the $2 million ($5MM-$3MM) cost $2 million more in operating expenses than they yield in gross margins, or $7.75 million. If these negative producing transactions were nullified, the distributor in the example would have $2 million in income to take to the bank or take to the street in price concessions to land the Big Fish.
The previous example is counter-intuitive and takes new measurements of profitability by transaction type. Our work in this area uses Differential Costing, a methodology of developing costs by transaction type. Differential cost by transactions find that most distributors think profit making is linear and follows a path similar to an income statement. In reality, profit making is a winding path and can vary greatly.
Simply stated, increasing sales and margin dollars can, and often does, decrease profits. Why? Because the sales could be in transactions that consume more in operating expenses than they yield in margin dollars. Profit making in distribution is much more complex than simply increasing sales and margin dollars. From a transaction viewpoint, profit depends on transaction size in margin dollars, cost of serving differing transaction types, and mix of transactions.
Figure 2: Transaction Profile
| Transaction Type | Sales | Margin Dollars | Differential Cost |
Transaction Profit | Profit by Transaction as % of Total Profit |
|
Stock Original Orders |
45,677,899 |
9,135,580 |
7,758,464 |
1,377,116 |
51.94% |
|
Direct Shipments |
22,567,084 |
3,836,404 |
2,134,566 |
1,701,838 |
64.19% |
|
Non-Stock Shipments |
11,345,678 |
2,836,420 |
3,156,420 |
-320,001 |
12.07% |
|
Counter Sales |
9,876,533 |
2,765,429 |
3,057,629 |
-292,200 |
-11.02% |
|
Stock Transfers |
14,163,522 |
3,257,610 |
2,950,882 |
306,728 |
11.57% |
|
Back-Orders |
3,567,899 |
820,617 |
942,961 |
-122,344 |
-4.61% |
|
Totals |
$10,718,615 |
$22,652,059.65 |
$20,000,921.77 |
$2,651,137.88 |
100.00% |
Some distributors are beginning to understand this and act accordingly. Consider the Differential Costs and Transaction Table of the distributor in Figure 2. The firm learned that approximately 127 percent of transaction profits come from three transaction types including stock original orders, direct shipments and stock transfers. Suppose the firm, which has $107 million in sales, has an approximately $10 million account whose transaction mix approximates that of Figure 2. Also suppose this account wants a significant price decrease. What is the firm to do? Using the transaction profile, management can work on the following sales tactics:
- Decrease non-stock shipments and move these materials to a direct shipment basis or — if their turns warrant — put the material in stock.
- Drive larger stock original orders by tying a larger order size to FFA terms or giving extra discounts on stock items based on order size.
- Not honoring back-orders or only honoring them on FFA orders.
- Raising prices on counter sales and non-stock shipments to smaller customers or on small transaction sizes within these transactions.
The above tactics are called Transaction Shifting (methods whereby sellers shift business to more profitable transactions in order to reduce the price). In the example above, direct shipments earn 64 percent of transaction profits. Switching non-stock volume to a direct shipment status can greatly improve profits. Also, raising prices for small-sized counter orders and non-stock shipments can mitigate loss and free up margin dollars that help keep the Big Fish.
The use of Differential Costing and Transaction Management are new fields that distributors will need to understand in tomorrow’s business environment. The continuing demand for pricing concessions by large customers will increase as economic growth slows and price sensitivity rises. We will explore other seller strategies including sweetspot pricing by transaction type in a future installment. For now, consider that if you don’t understand Differential Costing and Transaction Management and aren’t up to snuff on sourcing off-brands, you could find tomorrow’s environment increasingly difficult.
1. Benfield, S., Griffith, S., Disruption in the Channel, www.disruptioninthechannel.com, 2008, Power Publishing. Back to article
2. Benfield S., Griffith, S., Ongoing research at www.disruptioninthechannel.com, Distributor Research results, 2008. Back to article
3. Benfield, S., “The Changing Economics of Industrial Channels, www.benfieldconsulting.com/benfield_site/changing_economics.htm, 2008, Benfield Consulting article for Progressive Distributor. Back to article
4. Benfield, S., “A New Dynamic in Wholesaling,” Supply House Times, September, 2008, pg. 68, bNp Publications. Back to article
| Scott Benfield is a consultant for distribution and industrial manufacturers in durable goods markets. His firm and its work can be viewed at www.benfieldconsulting.com. Contact Scott at bnfldgp@aol.com or (630) 428-9311. |
This article originally appeared in the January/February 2009 issue of Progressive Distributor. Copyright 2009.
