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Big
changes for industrial distributors
Why you won’t be able to sell yourself out of trouble.
by
Scott Benfield and Jane E. Baynard
The latest profit figures
from the Industrial
Distribution Association (I.D.A.) show that its member distributors report profit of 0.4 percent of sales
or a return on net worth of 2 percent.
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Part
of the slide is due to
the dismal economy and the recession, now in its second year. However,
the decline is not only symptomatic of the lousy
economy, it is indicative of structural changes that have been brewing in
industrial markets for some time.
Distributors serving the MRO and OEM
manufacturing base 1
are advised to carefully consider our diagnosis of the problem and
prepare accordingly. One more year of the dismal economy at a 0.4
percent pre-tax level and the audience for our work will substantially
decrease.
When
did the slide begin?
The slide for industrial markets began long before the
current malaise. Starting in the early part of the last decade,
industrial distributors began an earnings decrease. Pre-tax earnings,
as a percent of sales, drifted downward from 1.9 percent in the late
1980s to 1.6 percent by the mid 90s.
Of course, anyone familiar
with this period knows that there was a slight recession in 1990 and
1991, but the economy roared back until the last half of 2000.
So, why
were industrial distributors’ profits decreasing in the boom economy
of the 1990s?
Get a
pricing grip on your integrated supply agreements
As early as 1998 2,
we were arguing against the cost-plus pricing model used in most integrated
supply agreements.
Our view of these agreements, supported by activity-based
costing,
was that the mechanism of placing a margin on the cost of goods was
the wrong thing to do. The risk in integrated supply or managed
inventory agreements is the operating cost needed to support them.
When a major customer signs over a large portion of its MRO or OEM
inventory to the local distributor, the customer becomes largely
dependent on the supplier for supporting services. In the early years
of integrated supply or managed inventory agreements, many sellers
were literally pricing them in the sub-two-digit margin range.
To support our claim, a quick glance at the 2002
I.D.A. profit
report finds that high-profit I.D.A. firms sell integrated supply
contracts at the highest gross margin. Our suggestions and suspicions
from 1998 still hold true and they are:
• Price these agreements on the incremental cost of service. If
you don’t know or can’t forecast incremental service costs, then
use standard operating expenses as a percent of sales for similar-sized customers.
• Build a pro-forma model of each agreement and discount it by
the cost of capital (see your accountant). Run sensitivity analyses on
the agreement to understand the different net present values and how
they vary by gross margin and operating expense fluctuation.
• Let a committee price these agreements and include
accountants, operations personnel and marketers. Most salespeople simply
don’t have the skill sets to develop realistic models of these
agreements and price them.
• Get an activity-based costing model or take a course on activity
costing. It helps in understanding how to allocate operating expenses to
these agreements.
Beyond this, beware of taking managed contracts for old-line
mature industries. Why? Simply put, mature manufacturing industry in
the U.S. is moving offshore. They often try managed agreements as a
last experiment to lower operating cost structure before they pull the
plug and put the plant in Asia or Eastern Europe.
We recently found a
pipe, valves and fitting distributor trying to justify taking a large contract for 7
percent gross margin with full knowledge that the customer -- a steel
manufacturer -- was on the ropes and quietly moving plants. If the
prospective integrated supply customer is in trouble or in an industry
where the plants are moving, think twice about taking the deal and
have the courage to walk away.
Learn
how to develop fee-based services
Fee-basing services is not as difficult as it seems. There
has been a heightened interest in understanding how to fee-base
services in industrial markets in the recent past. 3
The knowledge for developing services that can fetch fees is available4
and, from most reports, works. The idea that the distributor can keep
adding increasing value to commodity products without commoditizing or
negating the service value needs rethinking.
Unbundling the
service
from the product and pricing it separately works with new or higher-valued services. Why? Consider the following reasons and advantages in
separating services for fee income:
• Rolling services into the product price conditions the
customer to expect services for free.
• Services are the value that distributors manufacture.
Understanding them and marketing them aligns your company with the
controllable value.
• It is nearly impossible to measure if new services create new
product sales unless you unbundle them. Throwing a new service on top
of a mature product doesn’t give the detail needed to fairly
evaluate the service. And, the seller keeps repeating the same mistake if they give away a costly service.
• Services that are real winners, that are not fee-based, can
create a stampede of demand from all customers. This, in turn, can
overrun the distributor’s ability to supply a quality service,
whereupon the service quality falls and the customer leaves because of
a service that wasn’t priced to begin with. In short, fee-based services
separates customers that really value it from those that will
take it because it’s offered.
Fee-based services won’t totally turn the tide against the
market changes in industrial manufacturing, but it can pull in desperately
needed incremental dollars.
Reduce the
overcapacity in outside sales
Our research 5
has chronicled a severe overcapacity in outside sellers in industrial
markets. There are approximately 30 percent to 50 percent too many
sellers based on the research.
If these sellers can’t be deployed
for greater productivity, then the only recourse is to thin their
ranks. If thinning the outside sales ranks is unconscionable, then
refer again to the I.D.A. 2002 PAR Report.
High-profit
distributors had
3.7 percent of expenses in outside sales and 3 percent in inside
sales/counter personnel. The net difference of 0.7 percent was one of
the smaller gaps in these expense categories. Our sales research found
that inside sales were as valued to customers as outside sales and
high-profit distributors seem to be getting the message.
There may be hope in alternative models of sales
productivity. Currently, most distributors allocate salespeople by
geography. Geographic allocation, however, does not allow for a market-
based focus on any plane other than common geography.
Alternate models of sales allocation are too complex to
discuss in this article, but we encourage readers to follow readings
on segment, functional, consultative, enterprise, transactional and
hybrid/queuing. 6
New models of deploying sales personnel have been shown to be three times
more effective than simply adding more feet to the street.
Many distributors are hard pressed to reduce or change the
sales effort. Our feeling is that time has essentially run out on a
complement of just-in-case sellers. Customers aren’t willing
to pay for them and many will seek the distributor with low operating
expenses, a low price and reliable service.
There will be an
increasing use of catalogs, e-commerce and alternative forms of
solicitation. The planned solicitation of the customer contact effort
will become much more sophisticated with distributors alternating
catalogs, e-commerce and alternative models of deployment.
This
process, called hybrid marketing, is just now being explored. How
hybrid marketing will be used in distributed markets, and what the results
will be, are too early to tell. But all signs point to big changes in
the sales effort and time has run out on procrastination and wishful
thinking.
Segment and
diversify your markets
We have been talking about meaningful segmentation since our
first article (July 1994). Segmentation should set the stage for
pricing, service allocation, customer solicitation methods and where
to invest for growth.
Many industrial distributors are serving the old
line manufacturing markets and hoping that their sales will turn
around with the next recovery. Our advice is to research the future of
manufacturing as a percent of the gross domestic product (GDP).
The goods-producing portion of
our economy is continuing to fall as a percent of GDP. The current
percent of manufacturing to our GDP is somewhere around 18 percent to
20 percent. It has fallen significantly as a contributor to the
overall goods and services produced.
Manufacturing, however, has shown
significant productivity gains, and manufacturing output is
significantly higher than it was 10 years ago. The real problem is
that the service portion of the economy is growing much faster than
the goods producing portion.
What manufacturing is left will
increasingly be in the high-tech industries 7
and, while we are not forecasters of industrial product demand, our
guess is that high-tech manufacturing uses far less of the abrasives
and cutting tools common to old line manufacturing.
One can rightly ask what does segmenting markets have to do
with all this? Our answer is that if distributors were reading up on
the growth trends of their segments, they would begin to deploy their
salespeople to parts of the economy that are growing, including the service
institutions in health care and education.
There will still be a
powerful manufacturing base in the U.S., but don’t expect the mature
industries to stay stateside when lower labor costs and foreign
markets begin to industrialize. Segment your markets and move your
salespeople into areas of the economy that offer better growth
opportunities.
If
you can’t beat ’em, sell out
If you are not willing to commit to some major changes, our
advice is to consider selling. In
fact, your business may be worth more to someone else than it is to
you for the simple reason that another management team can leverage
the returns to a greater extent than you can in the current
environment.
Our series,
Selling a Distributorship 8
chronicles the process of divesting a wholesaler, from the decision to
sell to closing the transaction. We deal with key issues such as
valuation, tax effects, structuring the transaction and even viable
alternatives to an outright sale.
It is a must-read for any owner or
stockholder interested in learning how to extract a nest egg without
cracking the shell. Our advice is to plan the sale and move forward.
There is a definite overcapacity in distributors in U.S. markets. The
overall number of firms in wholesale distribution has declined
approximately 30 percent in the last 15 years.
We believe the market for
industrial distributors and those serving industrial manufacturing
won’t bounce back as they have in past business cycles. The
structural changes of mature industries moving offshore, overcapacity
in distribution (especially sales forces), the risks of managed
inventory agreements and the literal poverty of pre-tax returns
point to a tough environment for distributors in the coming decade.
New ways of management and thinking about distribution will be
required. Sales deployment will become more complex, the need for
market-driven growth will surface and cost management will be
increasingly more important.
Those who try to sell their way out of
the current malaise will find themselves pushing the square wheel of
stone up a 45-degree slope. In short, it’s time for a new set of
skills to right the business and the clock is ticking.
Scott Benfield and Jane E. Baynard
are consultants in finance, marketing, and operations for distribution
and industrial manufacturers. They can be reached, respectively, at Bnfldgp@aol.com
and jb@baymengroup.com.
1. Our definition of industrial distribution includes any distributor
serving the MRO, OEM, and capital projects for the U.S.
manufacturing base.
back to story
2. Pricing
the Managed Inventory Agreement, Supply House Times, First Quarter
1998.
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3. Our seminar to the I.D.A. on the subject, November 2001.
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4. See Services That Sell, NAW Publications, nawpubs.org,
1999, Benfield and Baynard-Authors.
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5. See “Valuing the Outside Sales
Effort,” Progressive Distributor, Jan./Feb. 2002.
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6. See Facing the Forces of Change, NAWPubs.org, 2003 Edition,
Benfield Consulting submission.
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7. OECD, The Economy in Perspective, Sept. 1999
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8. A Progressive Distributor
online exclusive series by Scott Benfield and Jane E. Baynard,
www.progressivedistributor.com
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