January 2004              return to the newsletter contents page

Is Your Value Proposition Really Working?

By Dr. Albert D. Bates

In recent years distributors have worked very hard to enhance the value they provide to customers. Operationally, service levels have been increased, order cycles have been shortened and error rates have been lowered. From a personnel perspective, customer service has become the way of life.

Concurrently, though, distributors have faced

severe price pressures. The very same customers demanding more service are also demanding lower prices. In short, distributors have been forced to provide more for less.

From a profitability perspective, more for less has always been problematic. At present, it seems a tarnished concept. For too many firms, the eroding gross margin is no longer adequate to cover the increased cost of providing services.

From a strategic perspective, this means that the value proposition that distributors are providing to their customers may not be working. Either customers do not fully appreciate the value being received or the cost of providing value to customers is excessive. Either way, it is untenable.

This article reviews the implications of a defective value proposition. It does so by looking at two specific issues:

• Measuring the Effectiveness of the Value Proposition—This is a somewhat imprecise undertaking. However, it is possible to measure this with enough accuracy to evaluate company performance.

• A Suggested Improvement Path—Moving towards a more profitable value proposition is easy conceptually, but challenging operationally. This section will suggest some areas to consider in that effort.

Measuring the Effectiveness of the Value Proposition

Enumerating the list of values that distributors provide to their customers is an almost endless activity. However, measuring the value that customers place on the list of services actually is quite easy. It is simply the gross margin that the distributor produces.

Gross margin is the difference between what the distribution firm buys goods and services for and what it sells them for. From a strategic perspective, gross margin represents how much of a premium customers are willing to pay distributors for the services they receive. Customers could, in many instances, purchase directly from the distributor’s suppliers and forego the services the distributor provides. Overwhelmingly, customers choose not to do so. The market places a value on the services provided in terms of gross margin.

Measuring the cost of providing the services is much more difficult. However, most of the services are directly related to human activity—sales calls at customer locations, making deliveries and the like. Consequently, a proxy for the cost of providing the services is total payroll—including salaries and all fringe benefits. Fringe benefits includes payroll taxes, health insurance and retirement programs, but excludes items such as uniforms, travel and company-provided laptop computers.

The Personnel Productivity Ratio (PPR) measures the percentage of each gross margin dollar that must be devoted to payroll. That is, it reflects the cost of providing services as a proportion of the value received for providing them. The first column of Exhibit 1 examines the productivity of the typical SEDA member. As can be seen, the typical firm achieves a PPR of 63.3%.

The 63.3% number means that for every dollar of gross margin the firm generates, 63.3cents have to be spent on total payroll expenses (again, including all fringe benefits). From both a strategic and a profitability perspective, the number is too high, probably way too high.

A Suggested Improvement Path

There are many misconceptions and arbitrary guidelines regarding the PPR. One of the most frequently discussed of these is that the PPR should be under 50 percent. All such statements regarding the PPR are nothing more than well-intentioned myths.

The only thing that can be said with absolute certainty is that lower is better than higher. How much lower it should be will always involve at least some level of conjecture.

The SEDA member profitability report, though, does provide a basis for targeting PPR improvements. The report indicates that while the typical firm has a PPR of 63.3%, the high-profit firm has a PPR of only 61.0%. There is a clearly measurable improvement opportunity of 2.3 percentage points that probably can be closed over time.

To close the gap, SEDA members should consider trying to lower the PPR by about one percentage point a year. If they can do so, they can build a stronger profit base for the firm.

The last two columns in Exhibit 1 reflect the impact on pre-tax profits in one year and five years from lowering the PPR by one point per year. For ease of focusing just on the PPR, sales, gross margin and non-payroll expenses have been held constant. These factors change every year, of course. However, by holding them constant for purposes of analysis, their impact on results can be eliminated, leaving only the PPR improvement.

As can be seen in the exhibit, a PPR reduction slowly, but systematically improves the firm’s bottom line. It does not produce dramatic improvements. What it does do is help rebuild a business so that its value proposition is working.

As useful as the PPR is, it does have one major flaw. Namely, it can be improved by lowering payroll, increasing gross margin or both. Consequently, it does not have the potential to focus the firm on the “one thing” that it needs to do to strengthen its value proposition. In most businesses, there is a requirement for both expense and margin improvements.

Payroll expenses, to a certain extent, have a mind of their own. Lowering these costs is far from easy. Most of the work in this regard will probably have to come from productivity enhancements. Even that is probably not enough. Eventually, distributors must think the unthinkable and determine what services actually need to be eliminated rather than made more cost effective.

Ultimately, attention also must be devoted to the gross margin side of the equation. In distribution in general over the last several years there has been a tendency to expand the service base without charging for it. More attention needs to be given to fee-based services. Ultimately, firms also need to address their basic pricing decisions.

Moving Forward

High-profit firms have an important profitability advantage over the typical firm today. A large component of that comes from better control of the PPR. The typical SEDA member must start today to close the profit gap by rethinking the value proposition they are providing.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

©2003 Profit Planning Group. SEDA has unlimited duplication rights for this manuscript. Further, members may duplicate this report for their internal use in any way desired. Duplication by any other organization in any manner is strictly prohibited. 

A Note on Calculating the PPR

Computationally, the PPR is simply total payroll costs (including all fringe benefits) divided by total gross margin. Using numbers for the typical SEDA member, the ratio is:

Total Payroll

Gross Margin

=

$1,671,120

$2,640,000

=

63.3%

This means that for every $1.00 of gross margin the firm generates, 63.3 cents must be devoted to payroll and fringe benefits. For distributors that have moved heavily into the sale of services, extra care must be exerted in calculating this ratio. The cost of labor hours sold should be included in cost of goods sold and not included in payroll expense.