Getting the cost out of wholesaler-distributors. 
What do we keep and what do we pitch?

by Scott Benfield and Jane E. Baynard

Many of the vertical markets we review are pushing hard to trim costs. Cost reduction, in mature markets, is an ongoing issue and one of the few axioms in business. Many wholesaler-distributor customers are sending clear and loud signals about the need for cost reduction from their suppliers. 

Part of the signal is due to the jockeying for a competitive advantage in the current recession. A substantial part, we believe, is that distribution has potential to streamline its operating cost base. 

Where the cost issue lands is largely a function of what wholesaler-distributors do in the near future. And this will start the domino effect for the competition to follow or lose. From our work, we believe there are some substantial areas of cost that can be reduced.

We also believe that accounting and accountants will not be the chief architects of cost reduction. Instead, the job will fall to operations, marketing and financial managers.

The behavior of wholesaler costs, limits 
of financial accounting and service allocation
Our perspective on cost reduction in service businesses is not typical. We strongly believe that much of financial accounting cost reductions simply do not last or they harm income streams. Why? Consider that distribution is a service business that manufactures service to maintain and increase income streams. Much of financial accounting uses financial ratios or benchmarks to review costs and then, if the ratios are unfavorable, cuts costs to come in line with their peers. 

The problem with this approach is that it is myopic, simplistic and doesn’t review the service quality of the operations base. In short, the cost measurement doesn’t consider operation processes and their effect on the customer satisfaction. And, cost improvement in a high transaction/low margin business involves careful, detailed changes to work processes.

To illustrate the issue, consider the experience of the controller of a large distributor that, through an informal benchmarking group, discovered the number of people processing customer credits was too high. He promptly reduced headcount in the department. Some months later key customers began defecting. What happened? He never reviewed the process to understand its limitations and never conducted service research to understand the importance of credit timeliness to customers. 

When we reviewed the issue, we discovered the credit process was inferior to other distributors, and customer need for immediate credit was high as they operated on low levels of cash. The controller hacked at the cost without understanding the steps in the process and how important the service was to the customer base. The result was a backlog of credits because of the reduction in labor and disaffected customers from delayed cash cycles.

When considering change to a major process, we advocate two rules. First, document the process flow and put time and cost estimates to each step. If the process is sloppy, you can often increase throughput and decrease costs simply by improving the process flow. 

Much of distribution’s cost (60 percent of operating expenses) is in headcount where rote processes are done by a plethora of people. Reducing the process steps can improve productivity to the point where heads can be reassigned, reduced or fewer added for future work. 

Second, understand the before and after satisfaction of the change in service. Service processes have real consequences on customer satisfaction and, unless they are carefully given process flows and their satisfaction is measured, then cutting costs often harms service and revenues often fall. Most distributors, unfortunately, never see the consequences of their cost hacking, as customers slowly defect sometime after the hacked service makes them dissatisfied. 

Far too many distributor managers hack costs, look like heroes in the short run, and foul sales up in the long run by reducing service quality.

Marketing, service alignment and 
fitting operations to segment needs
Distribution is also a notoriously tough business in which to reduce operating costs. The model of  business is three generations old and ingrained. The cost structure is composed of large levels of step-costs that rise as business volume rises.

The current model either treats all customers the same or allows sellers to determine many of the services a customer receives. In essence, many customers get specialized service with maximum flexibility and it is difficult to reduce costs in any meaningful fashion since it has to be done on a customer-by-customer basis. To reduce large areas of costs, distributors need to carefully segment customers, determine which level of service the segment needs and remove sellers from making individual service promises.

Segmentation can give the distributor the ability to reduce large areas of over-servicing, which is something sellers almost never do. One client, who segmented by size/growth, discovered that approximately $5 million in business went to small, infrequent buyers. They also discovered that these customers received a 1 percent cash discount for payment in 15 days. 

Based on the infrequent buying of these customers, their limited familiarity with payment terms and their high activity cost, the distributor decided to stop the 1 percent cash discount. The result was that the company saved more than $40,000 without a noticeable loss in revenue from this customer group.

To make this decision, the distributor had to segment customers, carefully analyze their service needs and link the services to the segment. Service policies must be programmed specific to the segment for consistency and control. Specifically, the I/T system, through the pricing mechanism, should develop a service pricing matrix specific to the segment. The matrix should specify delivery methods and prices, cash discounts and special services and their charges.

Many distributors deliver their services like a bowling ball. They roll up all services into a price slightly higher than the cost of operations. They then roll the ball at all customers equally. The result is that customers are often under-served or over-served and probably never served the way they want. When this approach doesn’t work, sellers then make individual service promises by account, which is on the opposite end of the spectrum from the bowling ball scenario. When sellers get involved in service policy it is a sure bet (according to the seller) that each customer has a need for the unique request. Of course, this means that the distributor has to be all things to all people and the operations upkeep of all the service promises causes operating costs to balloon.

Segmenting customers and allocating services by segment takes good marketing and operations. The segment is the best method to discriminate and match specialized services to customer needs while avoiding the bowling ball or salesperson service fiasco. And, don’t forget that the service platform should be attached to the pricing matrix for consistency. Careful allocation and determinations of services by segment can align and reduce costs similar to the previous cash discount example.

Old-fashioned budgeting and hard questions
An area where many distributors can reduce costs without a tremendous amount of risk is in non-headcount, non-cost of goods sold areas. Generally speaking, approximately 30 percent or more of operating expenses are spent on non-salaried areas. Many of these expenses, such as trucks, warehouses, I/T expenses, etc., are necessary for the business and are difficult to reduce. In many areas, however, some good old-fashioned budgeting, hard questions and shopping can substantially reduce the expense load.

Consider the experience of Distributor Z that, through acquisitions and organic growth, doubled its size in three years. Expenses quickly got out of control and management was in a pickle regarding customer-sensitive expenses because they did not have the time and information to effectively reduce customer sensitive processes. They did, however, attack support expenses with great success. Using our suggestions, the company listed all non-headcount expenses for the previous year and ranked them from the highest to lowest. Management then asked several simple questions about these expenses:

• Is this expense absolutely necessary to improve our performance and make the customer more profitable in increasing sales or reducing expenses?
• If the answer to the previous question is yes, then have we shopped the vendor recently or can the expense be delayed for a later period?
• If the answer to the first question is no, then get rid of the expense.

These efforts caused Distributor Z to do some rather seemingly innocuous things such as:

• Shop the paper vendor to save $25,000.
• Water and take care of its own house plants vs. a service to save $2,000.
• Get rid of donuts at the counter 5 days a week to 1 day per week to save $8,000.
• Negotiate a better scrap value for steel cuttings to gain $5,000 in revenues.
• Shop for a new vendor of laptops to save $300 per laptop at approximately 10 laptops per year.
• Negotiate a scrap value for broken pallets and wooden crate.
• Stop giving away printed pads and pens at the counter to save $14,000 per year.

Totaled, these efforts saved Distributor Z upwards of six figures, which went to the bottom line and helped greatly in trying times. If you haven’t reviewed and scrutinized the non-headcount support expenses, it is probably high time to do so.

A WACC on the side of the head!
WACC or the weighted average cost of capital can be a hidden source of untapped value in eliminating costs in a distribution business. First, let’s review what every finance professional knows, the four horseman of capital: long-term debt, preferred stock (not really a frequent flyer in the wholesale-distribution network), retained earnings and new issues of common stock. 

We conveniently ranked those in positions traditionally seen as cheapest to most expensive. In order to reduce the costs of capital, these levers must be tweaked. But how? Since debt is frequently a critical component of distributor’s capital structure, let’s focus our analysis on it.

Analyzing the cost of debt is easy. Simply review your interest rate and ancillary costs of borrowing on each layer of debt present on your balance sheet. In a distribution business, although bonds are typical, debt is a key component of your capital structure, be it working capital loans, lines of credit, supplier credit terms, mortgages on buildings, fleet loans for transport assets, etc. After determining your net borrowing terms, next compute the after-tax cost of same by multiplying your pretax cost of debt by 1 minus the company’s tax rate.

As you can see from the inputs, the two variables to focus on lowering are interest rates/terms and taxes. The tax component is highly important and yet another area for analysis (outside the scope of this article). But more often than not, it’s the interest rate and or terms that have a significant impact and are negotiable. For example, consider Distributor one vs. Distributor two. Distributor one has an aggressive CFO who shops his credit business and regularly renegotiates terms. He recently observed that rates are falling, so he renegotiated his credit. The result compared to his colleague at Distributor two are below:

Lowering your interest rate just 1 percent has an effect of a 10 percent reduction in the cost of debt, which in turn, can have a profound impact on your business!  However, get your creditor on the phone and negotiate better terms. Ask for a lower rate. Modify the payment terms. Change the duration. Shop around and consider hiring an investment banker. You can, in some instances, negotiate better terms on most of those instruments.

What costs will distributors keep?
There are some areas of cost that we believe distributors will control because the functions are absolutely necessary. These areas are accounts payable, warehousing costs of receiving, put away and shipping, purchasing, accounts receivable, and some level of inside sales or customer service. The place function and associated material flow functions are the core of distribution and will be needed as long as distribution is needed.

What is not certain is who will provide these functions. We are finding 3PL (third-party logistics) firms being outsourced in many areas, especially warehousing and shipping. We’ve also found distributors that have outsourced credit extension and collection to banks via credit card transactions. And, we recently found distributors using foreign service firms for payables and receivables. (One of our invoices to a wholesale client was paid by an India-based payables processing service.)

Consider the firm Spectramind of New Dehli, India. The company is a fast-growing service provider for U.S.-based companies. Essentially, Spectramind uses college graduates, fluent in English, and familiar with American business customs. These graduates are young, abundant and cost-effective. They work nights in India to correspond to North American days. Salary costs are approximately 20 percent to 30 percent of corresponding costs stateside, but telecommunications costs eat into savings. All totaled, however, using a foreign service can save an average of 50 percent over its American-based counterpart.

Our work has uncovered service providers in Ireland, Australia and Canada as well as India. Anywhere there is a well-educated English speaking populace and a low cost of labor can offer low-cost service support. Will these services handle distributor functions of accounts payable, accounts receivable, simple purchasing and even limited customer service activities of order expediting, order confirmation and order disputes? We believe they will, and the distributors that unbundle their costs and outsource them to more cost-effective areas will take the advantage to market.

The trend, if you’ve been reading our work, is simply the unbundling of the supply chain. We have often talked about creating and unbundling the distributor service base and we are pleased to find some distributors have outsourced core services where they were not cost competent. And, to thwart the naysayers, as long as the distributor controls the customer relationship, it is not at risk from the outside service providers taking over the distribution function.

What costs will we pitch or substantially reduce?
Our research on the value and use of the distributor outside sales force is consistent across multiple markets. In short, there are too many outside sellers and their deployment using a geographic sales territory is, frequently, inefficient. 

We see a reduction in sellers probably on the order of 20 percent in the short run and 50 percent or more in the long run. We also believe there will be new and different models of sales deployment to enhance productivity.

Many distributor sales managers use return on time invested (gross margin dollars per call/cost per call) as a metric of outside seller productivity. This leads to designing geographic territories to reach a preconceived salary level. This also creates the annuity selling condition where sellers get a piece of the account sales as compensation without incremental increases in sales.

We find many distributors rewarding sellers on accounts where there is no sales and margin growth. The result is that the seller becomes a drag on earnings as the account revenues flatten out. To understand this situation, we admonish sales managers to measure the incremental return on time invested (ROITI) for each account. Instead of looking at the annual margin dollars generated by an account and rewarding a fixed percentage of the sales, we suggest looking at the year-to-year change (incremental) dollars generated by the account and rewarding/not rewarding on the gain or loss. 

We also suggest reviewing the new models of sales deployment and whether or not they can be used for greater sales productivity.1 Currently, there are seven models of sales deployment that can be used to allocate the selling effort. Most distributors, sadly, are stuck using the geographic model.

Finally, distributors will become familiar with new mechanisms of pricing, service allocation and solicitation. Terms such as relevant cost pricing, flexible service offerings and hybrid marketing systems will need to be used to decrease costs and increase productivity of the marketing and sales functions. These methods of low-cost marketing are common to a new category of companies named Transactional Wholesalers.2  We will describe these systems in upcoming articles and believe them to be powerful new means of getting the cost base down.

Final thoughts and warnings
The areas of cost reduction, cost management and competing on costs will challenge many distributors. Most distrubition companies have hacked their way to short-term cost improvement without understanding the top-line sales impact on poor services. As strange as it sounds, good cost management takes an investment of time and money.

It requires substantial resources to document processes, reduce redundant steps, develop new models of sales allocation and new models of pricing, find competent low-cost service providers and understand new ways to solicit customers. Those who invest in cost reduction and cost management will benefit from the unbundling of the supply chain. 

And, the $64,000 question is how much cost can come out of the average distributor? We have recorded transactional distributors that operate at cost levels that are a full 50 percent less than their traditional counterparts.

It is highly possible, in the not so distant future, to buy a product made in Eastern Europe financed by an American manufacturer and distributed by an American distributor that gives order options of e-commerce or outsources customer-assisted ordering to India. The product will then be warehoused and shipped from a local facility owned and operated by a third-party logistics firm, and the manufacturer payment will be processed by an accounts payable service based in Canada. And, finally, the distributor will be paid by a Japanese bank that handles the customer credit via a credit card service.

1. Facing the Forces of Change, Distribution Research and Education Foundacation, 2003 update, Scott Benfield submission
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2. See the “Rise of the Transactional Distributor”
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