Consider the following dilemma: A wholesale distributor has
two customers: Customer A and Customer B.
Customer A and
Customer B each place a $1,000 order. Each order has a cost of goods sold
of $700.
Does the wholesale distributor make the same profit from each
customer?
The traditional wholesaler might analyze the question from a
gross profit perspective. It seems to be a simple calculation: The
wholesaler made $300 of gross profit from each order. But,
something interesting emerges upon a more thorough look at the amount
of activities and services provided to the distributor’s customers.
Customer A called in the order, picked it up and paid
immediately. Customer B’s order was called in by a commissioned
salesperson. Customer B called in several more times to make changes
in both the items needed and the quantity needed. Customer B also
wanted the product delivered to its site. And Customer B bought on
credit with 45 days to pay.
Unfortunately many wholesale distributors have no way of
easily and consistently estimating the cost of services to their
customers. Yet there are approaches and tools available to assist the
industry in tracking the cost of services and ultimately determining
which customers are profitable and what to do about unprofitable
customers.
However, pricing and margin pressures changed these dynamics
in the 1990s.
Wholesale distributors
experienced deceasing margins due to cost transfer on both sides of
the value chain. Manufacturers reduced their costs by eliminating
local sales support staffs and transferring those tasks up the supply
chain. Customers eliminated fixed costs of assembly, inventory and
design and transferred these costs down the supply chain.
Both trends
increased the cost for the wholesale distributor.
While raising prices would
seem logical, the ability
of the wholesale distributor to increase prices was minimized due to a
multitude of pressures: Internet auctions, industry consolidation,
foreign competition and mega-warehouse channels. The wholesale
distributor was not only functioning in the middle, but caught there
with growing operation costs, increasing cost of goods and the
inability to raise prices to customers to regain margin.
Wholesale distributors receive a margin or price for a bundle
of activities they perform for manufacturers and customers. That
margin, minus wholesale-distributor costs, has whittled down to 1
percent or
less in recent years.
Wholesalers must understand that value
identification and customer profitability is a necessary step toward
regaining margin. Identifying which activities add value and at what
cost, and eliminating activities that do not add value for
manufacturers’ customers is critical.
But before this can happen,
wholesale distributors must understand their costs and their value
proposition.
Three significant factors impact wholesaler profitability:
bad credit, bad inventory and bad customers. The wholesalers can
control, measure and track inventory and credit, but they do not have
a systematic way of determining unprofitable customers and what to do
about them.
Wholesale order staffers use whatever history, company
guidelines, and verbal discussion, rules of thumb they can find to
make pricing decisions. One particular software tool used by order
staffers shows gross profit percent for each quotation, but it does
not reveal anything about the customer or the costs involved in
selling to the account.
The software leaves unanswered such questions as:
• Should we implement a delivery charge?
If so, should it apply to all customers and if not, who should
we charge?
• Should we implement a minimum order charge?
• Should we break a standard package?
• Should we discount from the standard pricing and if so,
how much?
• Should we make a special delivery, breaking from our
normal route?
• Should we charge a re-stocking charge for product that we
typically have on the shelf?
• Is 10 percent margin acceptable and if so, when, why and
for who?
At present, most wholesale distributors do not
have adequate cost information to help them make good pricing
decisions. The wholesaler does not know where the inefficiencies exist
within their operations and among their customers.
When wholesalers
can identify which customers use which types of resources and
services, they can more effectively match expenses and revenues and determine more appropriate customer pricing and
profitability. This can benefit both manufacturers and wholesalers.
Wholesaler distributors can improve profitability without conflict
through lowering unneeded services and costs and the manufacturer has
a more efficient channel to the market.
To quote a manufacturer:
“Distributors are always trying to justify their margin instead of
trying to figure out what is of value and eliminating the rest.”
An approach and a tool that can assist the wholesale
distributor in the price/cost /value proposition discovery process is
activity-based costing (ABC). The first step for wholesale distributors
in developing a value-oriented market offering is to determine if
there is a demand for the offering/activity.
The next step is to
determine if the offering/activity can be offered at a price the
market will accept. Wholesale distributors that do not understand
their cost structure tend to price products and services on a
traditional total cost structure. ABC can assist in a critical
evaluation process.
To begin the process of implementing an ABC cost and pricing
model, resource centers must be identified.
Resource centers
typically consist of fixed and/or indirect overhead costs. Each
resource center cost is tied to an activity. Activities are the
variable and direct costs associated with the service or product
offering.
Typical examples of activities are selling, shipping,
purchasing, and so forth. Each activity requires a driver such as an order, a
line item, time or space. These drivers initiate all activity
and expenses for a given resource center. Activities consume resources
and the consumption of resources increases cost.
Using ABC, a wholesale distributor can effectively tie
resources to products and price. The steps in the ABC
process are as follows:
•
identify resource centers;
•
assign expenses to resource centers
•
collect resource center activity data;
•
calculate resource center unit costs;
•
identify activity centers;
•
assign resources to activity centers;
•
assign direct expenses to activity centers;
•
collect activity data;
•
calculation of the activity-based costs;
•
collect customer activity data; and,
•
perform customer profitability analysis
The ABC process allows companies to determine the actual cost
of doing business with each customer.
Returning to the original
question of what profit the wholesale distributor made from Customer A
and Customer B, the question now must be modified to read: Did the
wholesale distributor make $300 of profit contribution from both
Customer A and Customer B?
Keeping in mind profit contribution is
sales minus the cost of the goods, less all the related
activities/services attached to providing the sales, Customer A made
profit of slightly less than $300 when the cost of order taking and
preparing the order for the customer was factored in. Customer B made
significantly less profit than Customer A when all the services
provided to make the sale (sales commission, multiple order taking,
delivery and accounts receivable, carrying costs) were taken into
consideration.
The ABC process enables a company to determine how much
profit contribution was earned from each customer and whether or not
the company is selling to customers at a loss after all related
activities are factored in.
Current
state of wholesale operations
Current pricing systems include some form of baseline
pricing dictated by customer type, such as OEM, contractor, industrial
plant (MRO), large, small, and others.
The order entry/salesperson is
allowed to deviate from that based on GP percent and/or order size. The
deviation is rarely based on logic, rather on a gut feel for
what needs to be done to secure the order.
The main cause for pricing
variances is that there is no time for any research, and as a rule, a
business receives only 30 percent of what is quoted. The quotation
departments are typically pressured to respond quickly and move on to
the next customer. Pricing guidelines are disconnected and the only
real control lies in the company minimum GP percent. The company minimum is
rarely published; instead, company culture dictates guidance.
To
view a screenshot of a typical sales/order entry screen, click
here.
Once
the services and costs are evaluated from the ABC software
application, wholesale distributors are in a position to show the
value added and kind of services provided to customers and
manufacturers, to better negotiate with manufactures on services
provided, and to enable and empower employees to make cost and value
effective decisions. In other words, make the unprofitable customer
profitable and the profitable customers more profitable through
informed actions and decisions.
The wholesale industry desperately needs to create a new
business model that will identify costs and value added.
The current model of pricing using gross profit margin is
inadequate to capture the true cost of services provided to customers
and alternately, whether a customer is profitable or not.
As customers and manufacturers continue to transfer costs to
the wholesaler, ABC can provide the wholesaler the tools needed to
modify their business model and recover their profits.
The process will also identify the weaknesses in the
traditional pricing model, some
of which included:
•
focuses on total costs, which provide little insight in
the nature of the service the customer is purchasing;
•
arbitrary allocation of costs results in pricing that is
difficult to defend;
•
fails to provide adequate information for decision-making;
•
does not reveal competitive advantages or weaknesses
within the organization;
•
does not provide information pertaining to individual
customers.
There has been much published over the past several years on
ABC and why it is important for the wholesaler. Unfortunately, the software to use the information has not
been readily available until recently.
With the systems now available to automate the process, ABC can
easily assist the wholesaler in tying the actual cost of transactions
to customers, reducing non-value added services, or demonstrating
value added and pricing appropriately.
With this knowledge, management can better control the cost of
services provided to each customer (deliveries, order taking, sales
calls, accounts receivable carrying costs, and more) and ultimately become
more profitable.
Even
though activity-costing accuracy is important, the key is to identify
a starting point and adjust as systems become more automated and
information becomes more readily available.
To
review screen shots of the software, click here.
Marketing Management,
Kotler, pg 533 Activity Based Costing -
You Can Do It, David Massie
Thomas
L. Lyon is a professor of finance in the Helzberg School of Management
at Rockhurst University. He is an active consultant and works with
many companies educating managers on the impact of measurement. He can
be reached at Rockhurst University 1100 Rockhurst Road, Kansas City,
Missouri 64110, Phone 816-501-4092
Fax 816-501-4650 E-mail Thomas.Lyon@Rockhurst.edu
Anthony
L. Tocco is a professor of accounting in the Helzberg School of
Management at Rockhurst University. He is an active consultant,
working with many businesses in the Kansas City, Mo., metropolitan
area. He can be reached at Rockhurst University 1100 Rockhurst Road,
Kansas City, Missouri 64110, Phone 816-501-4879 Fax 816-501-4650
E-mail Anthony.Tocco@Rockhurst.edu
Bruce
Droge is a current employee of Barr-Thorp Electric, a regional
electrical wholesale distributor located in Merriam, KS, (Kansas
City). Bruce started in the industry as a sales person for Square D
Company and has spent the last 10 years working in the electrical
distribution industry working in sales, sales management, and
operations. He received his bachelor from Kansas State University in
Electrical Engineering Technology in 1987 and his masters in business
administration from Rockhurst University in 2003. He can be reached at
Barr-Thorp Electric Co., Inc. 9245 W. 53rd St. Merriam, KS
66203 Phone 913-789-8840 Fax 913-789-8800 E-mail drogeb@barr-thorp.com.
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