Channel lessons

What the industrial supply channel can learn from the electrical supply channel

by Doug Levin

It is interesting to notice the different ways that separate vertical markets work. Distributor and manufacturer members of one channel can learn a great deal simply by observing the unique terminology or processes another channel uses.

Take, for example, the issue of manufacturers offering a reduced price to specific end-users. They might offer a discount to a customer that buys in large volume, or to a key account. Often, the manufacturer negotiates a selling price with the end-user and the distributor must honor that price in order to receive a lower-than-standard price from the manufacturer.

In the industrial supply chain, when a manufacturer and an end-user agree to a lower-than-normal price, the manufacturer typically issues a contract number denoting a specific cost for a product or group of products covered under contract with a specific end-user. Whenever a distributor buys the product for that customer, it notes the contract number on the purchase order. Some people refer to this as “mark for” which means mark this order for a customer.

How the industrial channel does it
Say an industrial distributor — let’s call it Distributor A — buys 1/4-inch drills from a specific manufacturer for $1. But Distributor A has an agreement with the manufacturer to pay only 60 cents per unit when it sells the drills to Ford for 80 cents. Say Ford buys 300 drills a month from Distributor A, and the distributor’s other customers buy 3,000 of the same drills a month.

Distributor A tries to keep a two-week supply in house.  But since Distributor A must stock the drills based on who will buy them, it must predict which customer will buy in any given time period and either stock them as two different items, or conduct a lot of manual processes. And, what happens when Distributor A runs out of inventory purchased at one price and needs to substitute it with inventory bought at another price?

From a manufacturer’s perspective, the process appears to work well. When the manufacturer gets an order from the distributor, it lists the name of the customer buying the product so the manufacturer can fill the order at the proper cost. But what happens when a distributor wants to return product because of an over stock situation? What cost is used on the returned item? 

Plus (not that this would ever happen), what keeps a distributor from telling a supplier that the product isn’t really intended for another customer? Or, what keeps a supplier salesperson from telling the distributor to do exactly that, because that’s easier than approving a new contract? This practice likely costs suppliers millions of dollars a year in lost revenue.

Even though the distributor might benefit from the supplier’s lost revenue, wasted process costs and carrying charges quickly eat up any financial windfall.

Fortunately, there is an alternative. The electrical and medical segments seemed to have mastered this.

How the electrical guys do it
As described earlier, an end-user and a manufacturer have agreed to a lower price than what other end-users pay, and the distributor must honor the agreement. Three factors complicate this situation:

• The product is a stock item.
• The product is sold to many end-users.
• When the distributor buys the product, it doesn’t know which customer will buy the product.

To complicate matters further, the price is sometimes lower than the distributor’s cost. To remain competitive and support its distribution channel, the supplier agrees to reduce the cost of the product to the distributor that sells to this particular customer. 

Realizing that it’s impossible to know at the time of the purchase which customer will buy the product, the electrical industry eliminated the guessing process. This solved several problems:

• Distributors no longer warehouse extra inventory for specific customers.
• When suppliers receive a purchase order, they do not need to worry about who the end-user will be.
• Supplier pricing is easier, since the price is always standard at the time of shipping.

Now the issue becomes, how do distributors get their money?

In our original example, if Distributor A sells 1/4-inch drills to Ford, the distributor’s cost is 60 cents per unit, but it pays $1 per unit to the supplier. Every time Distributor A sells a 1/4-inch drill to Ford, it earns a 40-cent rebate from the manufacturer. They call this process a “rebate,” although some industries call it a “ship and debit” (a distributor ships the product and debits the supplier).

Let's walk through the process again. Distributor A buys a 1/4-inch drill bit at $1, then sells the drill bit to Ford for 80 cents. It appears that the distributor loses 20 cents.

What really happens behind the scenes is that when Distributor A sells the item to Ford, the distributor’s business system recognizes it as a 40-cent rebate item for Ford. One dollar minus 40 cents equals the 60 cents purchase cost for distributor A. From a financial perspective, inventory is reduced by $1, cost of goods sold increases by 60 cents, and the rebate amount increases by 40 cents.

Now, whenever a distributor wants to claim its rebate – daily, weekly, monthly, etc. – it runs a rebate report directly from its sales history system. The supplier has tighter controls on the process and is sure that it charged the correct cost to the right end-user. The reduction in overhead and cheating (not that it would ever happen) puts money on the bottom line for both the distributor and the manufacturer.

A key point is that the cost of goods sold, sales commission and financials are calculated correctly on the front end. In the above case, the cost is now 60 cents, and the gross profit is 20 cents when the order is processed.

This rebate process has worked well for electrical distributors for many years, has reduced the cost of doing business, and has increased the level of trust between suppliers and distributors. It would be well worth it for industrial distributors and their manufacturer partners to adopt the same system.

Doug Levin is executive vice president for Prophet 21, a leader in providing durable goods distributors with innovative, adaptive enterprise technology solutions and services essential for running their businesses and reducing transaction costs to maximize profit and growth. Reach him at 800-PROPHET or at dlevin@p21.com, or visit www.p21.com.

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