Strategies for commodity deflation

by Adam J. Fein

The U.S. wholesale distribution industry is going through a period of remarkable, top-line revenue growth. Lines of trade as diverse as industrial products, pharmaceuticals, and plumbing/HVAC are all registering double-digit growth. Ironically, this growth surge is now setting the stage for a potential competitive challenge for wholesaler-distributors. Our new research study Facing the Forces of Change: Lead the Way in the Supply Chain describes specific strategies for navigating this coming challenge.

Top-line revenue growth comes from selling more products (increasing volume), achieving higher prices for those products (raising prices), or a fortunate combination of both factors. While the current economic expansion boosts unit volume, wholesale distribution executives must recognize that unusually high commodity price inflation is making revenue growth much easier to achieve. In recent years, prices of certain core commodities have literally skyrocketed. For example:

• Steel mill products increased in price by more than 60 percent since mid 2003. Although prices began to decline in the second half of 2005, prices remained relatively high by historic standards, due in large part to China’s commodity-intensive manufacturing activities. (China’s imports of all commodities have risen more than tenfold in the past 15 years.)

• Oil remains nearly $60 per barrel versus $32 per barrel in late 2003, triggering energy-related price increases throughout the supply chain and increasing the prices of derivative products. For example, prices for plastic pipes and fittings are now growing at 20 percent per year.

• Prices for building materials, such as lumber products, spiked in 2004 and remain above historic levels. Inflation for concrete products remains high as demand continues to exceed supply.

Changing price environment
The changing pricing environment is evident in the stage-of-processing category from the Producer Price Index (PPI) that measures intermediate materials, supplies, and components. This portion of the PPI is representative of wholesale distribution because it includes both semi-finished goods (such as steel mill products or lumber) and nondurable items purchased by business firms as inputs for their operations (such as diesel fuel, industrial supplies, or paper boxes). After barely increasing from 1992 to 2002, the intermediate materials, supplies, and components portion of the PPI has jumped by 28 percent since 2002.

This commodity price effect has increased top-line revenue growth for the wholesale distribution industry. Before adjusting for the inflationary effect of changing product prices, year-to-year quarterly revenue growth averaged 6.1 percent from 1993 through 2002. Although the gap between adjusted and unadjusted growth fluctuated throughout that period, the wholesale distribution industry still experienced consistently positive real growth averaging 4.5 percent.

The situation in 2007 is substantially different. Year-to-year quarterly revenue growth averaged a healthy 6.8 percent from 2002 through mid 2006. However, the average growth rate drops to only 1.9 percent after adjusting for inflation. In other words, the wholesale distribution industry has experienced limited real growth in the past 2 years, despite historically comparable top-line revenue growth.

Preliminary data from the fourth quarter of 2006 shows slow growth in the intermediate materials, supplies, and components portion of the PPI. We do not yet know whether this is the end of the commodity price bubble or merely a temporary pause.

Once commodity price growth returns to historic norms, then wholesaler-distributors are going to have to work harder for real growth. The revenue-enhancing benefit of product price inflation will dissipate as the growth in commodity prices eases. It will become harder for wholesaler-distributors to show top-line revenue growth, thus making volume growth more important as a source of revenue growth. Total gross margin dollars will shrink even if gross margin percent remains stable.

Monitor and prepare
No wholesale distribution company has the power to influence overall commodity prices. Therefore, the best approach to this emerging trend is through the following careful monitoring of external trends and strategic preparation:

Analyze recent growth. An over-reliance on inflation-boosted growth indicates that a revenue slowdown is coming to your company. Wholesale distribution executives should analyze the relative contributions of volume versus price growth to their companies’ recent top-line revenue growth. How much would your top-line revenue growth slow down if product prices remain flat over the next 24 months?

Tighten inventory control. Wholesaler-distributors can benefit from overall increases in prices by placing larger orders in advance of price increases. However, flat or declining prices create opposing dynamics for leaner inventories. The demand-driven channel models, described in Chapter Two of Facing the Forces of Change: Lead the Way in the Supply Chain, can help both manufacturers and distributors to better manage their respective inventories by sharing certain supply chain data.

In a demand-driven channel, shipments can respond more closely to real-time or near real-time (daily) information that is shared across a network of customers, wholesaler-distributors, and suppliers. Wholesaler-distributors that share information with suppliers should expect higher service levels from those suppliers. Wholesaler-distributors that gather better data from customers, such as through vendor-managed inventory arrangements, can simultaneously reduce inventory levels and the risk of stock outs. By 2012, 36 percent of MRO supplies wholesaler-distributors and 44 percent of OEM and production materials wholesaler-distributors expect to be sharing point-of-sale data with more than 10 suppliers.

Evaluate new profit sources. Deflation wreaks havoc with the income statement of wholesale distributors that are “paid” for providing services to customers and suppliers in the supply chain in the form of gross margin. Product price deflation translates into fewer gross margin dollars to pay for the value that these services actually provide.

Wholesale distribution executives should accelerate the development of fee-based services to avoid a profit squeeze caused by external pricing dynamics. A critical mass of wholesaler-distributors across all industry segments now offer fee-based services, consistent with the projections made in our earlier reports. Skepticism has now been firmly replaced by real-world success.

Some distributors still lack a culture of getting paid for advice instead of simply being paid with gross margin dollars from a product order. One executive at a fluid power and motion control distributor expressed a more forward-thinking viewpoint: “The next 5 years will be an excellent sales growth time for companies that adapt to the needs of customers: Vendor-managed inventory, vendor-managed maintenance, in-plant engineering, and technical support will all be areas of growth opportunities. It will be an exciting and challenging time. We plan to adapt product offerings with technical expertise to a decreasing manufacturing base.”

© 2007 Pembroke Consulting Inc.  Adam J. Fein, Ph.D. is the founder and president of Pembroke Consulting, a firm that provides business and marketing strategy advice to executives operating in channel-intensive industries. He can be reached at (215) 523-5700 or on the Web at www.PembrokeConsulting.com . This article is adapted from the new report Facing the Forces of Change®: Lead the Way in the Supply Chain, which is available online from the National Association of Wholesaler-Distributors at www.naw.org/ftf07.

This article originally appeared in the March/April 2007 issue of Progressive Distributor. Copyright 2007.

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