by David R. Massie

You have undoubtedly already read many articles and papers on the subject of activity-based costing (ABC). For that reason, I won’t rehash all the basic details about ABC. Suffice it to say that ABC provides a source of unique information about how an individual customer consumes distributor activities and resources and how that translates into profitability.

As customers continue to force prices down, distributors are left with a couple of options in the search for more profits. The first option, of course, is to cut costs. The problem is, as customers demand lower prices, they also demand more services. Distributors are expected to provide basic services like delivery, bar coding, special inventory and field sales support, but also provide a combination of more expensive services such as:

• Technical support

• Cost savings

• Process improvements

• Quality programs/ISO certification

• 24-hour support

• EDI

• Point of use inventory

•Tool crib management

•Vendor consolidation

• Specialists in the fields of fluid power, material handling, cutting tools, abrasives, electrical, and power transmission

The customer sees all of these as being part of the package. They never consider that the distributor does not take these costs into account before agreeing on a price. The best chance distributors have to recoup the cost of these services is to negotiate their value with the customer. With activity-based costing, distributors can accurately cost these services and present them as value added to the customer. The customer then can choose which services are worth paying for.

Distributors are not created equal
Services and types of cost vary greatly from company to company. Some distributors make extensive use of delivery services, while others have their own fleet of trucks. Some use a central warehouse to resupply branches, while others perform purchasing at the branch level. Some are heavily involved in integrated supply, which brings with it a whole new set of operating costs.

There are many definitions and descriptions of integrated supply, each entailing a different method of handling customer orders and purchasing product. In some cases, integrated supply simply means the distributor’s salesperson or delivery person refills bin locations at the point of use within the plant.

To others, it refers to the consolidation of purchasing in which a single distributor buys a number of product lines from various other distributors and is paid a percentage for consolidating the purchasing function for the customer. The current focus of integrated supply seems to be on tool crib management, where the distributor displaces the customer’s tool crib operators and purchasing personnel and maintains a presence in the plant. Ownership of supplies remains with the distributor until they are issued to the end-user. Because this type of system is being widely talked about, I’ll focus on this tool crib management idea and how ABC relates to measuring the profitability of such customers.

Faulty assumptions
Integrated supply or tool crib management does not necessarily mean a cheaper way of doing business. In fact, in most cases, it is more expensive for the distributor, especially in the first few months of a new integrated supply agreement. Many distributors assume that an integrated supply deal must be profitable because the distributor is given a greater share of the business. “I can’t lose money on that account. Look at all the business I have,” they say.

Another faulty assumption distributors make is that they can afford to operate on a smaller margin because the dollar volume makes up for a loss in gross margin percentage. Don’t fall into such faulty assumptions. Tool crib management can be a tough way to make money. The distributor must know all of the costs involved in order to negotiate a price that will produce profits.

The costs incurred in servicing an integrated supply site can be quite different from those created in the normal distributor branch operation. The fact is more costs are dedicated to that one account as opposed to being shared by many accounts. That makes it even more important to identify all the associated costs and assign them to the integrated supply customer.

Some costs are not obvious. In most cases, a distributor undertaking a tool crib management project strives to create autonomy in the way the store room operates. The idea is that the crib operates as an individual branch, doing much of its own purchasing and sales activity.

Many expenses are overlooked because the site is viewed as a stand alone branch. Don’t be fooled. They can still consume as much or more resources than a normal customer. Integrated supply sites, of any type, must be viewed as a customer of the distributor branch, and measured according to the resources drawn from the branch.

The most cost-efficient tool crib management site is one that achieves a high level of autonomy, using few distributor branch resources. Any work done at the branch for the integrated supply site creates duplication. Inventory stored offsite at the branch creates double receiving, stocking, picking and packing work. Those operations are done once at the distributor branch and again when the product reaches the customer store room. The same is true of the purchasing process.

Granted, it will be necessary for the integrated supply site to pull some inventory from the branch, but this should be done only when the quantity/price break equation makes it worthwhile. If all or most of the product purchased by the integrated supply site comes through the branch, the benefits of integrated supply have been negated and the distributor would probably be better off servicing that customer in the conventional way.

Beyond the costs incurred in branch order processing, the distributor must be aware of how much activity from field sales, technical support personnel or specialists are devoted to an integrated supply account. The integrated supply customer may continue to use these resources in addition to the distributor personnel running the store room.

Other distributor costs to take into account include accounting department expense for invoicing and payables, data processing time and equipment and other company overhead. These can be difficult to track, but should be assigned to the integrated supply customer just as to any other type of account.

Another important aspect of costing an integrated supply site is to measure start-up costs. In a full-blown tool crib takeover, the set-up, organizational, training and inventory costs can easily run between $25,000 and $45,000. Most of this will be in personnel expenses, but the cost of shelving, racks, bin boxes, office equipment and other items can quickly add up and must be accounted for in the profitability equation.

The two lists below contrast activities that drive costs in the service of a normal warehouse customer and the management of a tool crib account. The important thing to remember is that the warehouse costs created on the left are shared by a large number of accounts while the costs created by the tool crib management site are (for the most part) dedicated to that one single account.

Before committing to a price, the distributor should create a comprehensive expense statement like the one shown on this page. The example is based on actual distributor costs. Your numbers may vary. The purpose of the example is to get you thinking about the variety of costs you may incur in an onsite inventory management program.

Detail all costs of your integrated supply operation. You may have to estimate some areas, but many can be accurately measured beforehand. Include all start-up expenses and any branch expenses such as inventory handling, purchasing, accounting and company overhead. From that foundation, you will be able to either negotiate a profitable integrated supply deal or determine that you should not enter into such a deal with a particular customer.

Be clear about pricing terms and be aware of contingencies that may develop that could drive up the costs of servicing the account. As with any other type account, the expense of servicing an integrated supply account is directly related to the amount of activity and distributor resources consumed by a customer. The best insurance for making a profitable integrated supply deal is accurate and complete cost analysis.

David R. Massie is director of activity-based costing for Industrial Distribution Group, Tucker, Ga. He can be reached at (864) 268-4281.

This article originally appeared in the May/June '99 issue of Progressive Distributor. Copyright 1999.

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