October 2004              return to the newsletter contents page

The Five Pillars of Financial Success in Distribution

Implications from the DPR Report

Distributors have started the journey back to higher profits after the recent recession. There is a feeling that even if the good old days are not yet back, at least they are on the horizon; business as usual is all that is needed. In fact, “business as usual” will probably not be close to good enough to generate desired profit levels. Initial indications are that distributor profits are going to bounce back, but to a level that is lower than in the past. There is also an indication that the differences between profitability winners and losers will become even more pronounced in the future.

In short, it is much more than a time for optimism. More fundamentally, it is a time to broaden the vision of the company. Distributors have the potential to build profit relationships that will endure for the next decade. Doing so requires taking action now. This management report examines the profit opportunities and challenges facing SEDA members. It does so by drawing heavily upon the 2004 DPR report sponsored by SEDA. Two issues will be examined:

• The Profit Gap—The profitability penalty that the typical firms pay in comparison to its more successful brethren.

• The Five Pillars of Financial Success—An examination of the framework for action that firms need to adopt to ensure they not only survive but also prosper in the future.

The Profit Gap

SEDA has always been a two-tiered industry with regard to profitability. That is, there has always been a measurable gap between the typical firm and the high profit one. Such a gap is inevitable.

The concern is that the gap has now reached a size that represents a long-term threat. The more successful firms not only generate higher profits today, but will be able to use their higher profits to expand their market share significantly in the future. It is a situation with ominous implications.

To understand the nature of the profit gap, it is useful to look at Exhibit 1 which draws information for both the typical and high-profit firm from the DPR Report. For ease of analysis, the sales volumes in Exhibit 1 have been set at equivalent levels, even though in reality the firms are of different sizes. This has been done so that sales volume differences do not impact the comparison.

The real implication from the exhibit is that these two firms don’t produce slightly different profit levels, they produce dramatically different ones. The high-profit firm generates an additional $330,000 on a pre-tax basis. This translates roughly into an additional $231,000 after taxes that can be used to invest in new technology, open additional branches, upgrade training efforts or add new staff. Over time, it provides the basis for slowly, but inexorably driving higher market share, higher sales and still higher profits. In the long run, an uncontested profit gap portends the demise of the typical firm.

No firm wants to be left behind. The challenge is that in a very busy world where sometimes everything seems important, there is difficulty in laying out a plan of action for the future. Closing the gap will require not only priorities for action, but an entirely new focus on what the firm is trying to be.

The Pillars of Financial Success

In closing the gap, there is an inevitable desire to find the silver bullet that will drive the firm to improved results. Unfortunately, there are no silver bullets for producing higher profits in distribution. Instead, success will come from doing a lot of things right over an extended time period. Firms must have a clear strategy, operate efficiently, understand the needs of customers, and engage in a myriad of other activities as effectively as possible.

Even though there are no magic answers, a detailed analysis of the DPR Report and comparisons with other industries does suggest that there is a definite “short list” of factors that distinguish the successful firms from the ordinary ones. Given their importance, these factors are being referred to here as the five pillars of financial success.

They are not five actions to take and then check off on a to-do list. Further, they are not five profit drivers to worry about, such as sales, gross margin and inventory. Instead, they are five fundamental characteristics of firms that enjoy long-term success. The five factors listed below are all strategic in nature. They describe the competitive and operating environment the firm has created.

• Barriers to Entry—Competitive battles are not fought on every item on every transaction every single day. Instead, competition is waged between alternative business systems.

• De-Commoditization—The overall product assortment offered allows for both tonnage sales and reasonable margin opportunities from non-commodities.

• Employee Productivity—New procedures for controlling payroll expense have been implemented.

• Profit Focus—The maximization of dollar profits takes priority over the maximization of sales or the minimization of asset investment.

• Internal Profit Understanding—There is a clear understanding within the decision-making ranks of how profit is generated or destroyed by employee actions.

Focusing on these strategic factors provides no absolute guarantee of success. Brilliant strategies can be combined with ineffective operating procedures to produce marginal results. Instead, concentrating on these five factors creates an environment in which effective operations can deliver high profits. Without such approaches, high profits are distinctly unattainable regardless of operational efficiency.

Barriers to Entry

Economic theory contends that barriers to entry are industry-wide conditions. If it is impossible, or at least very difficult for new competitors to enter an industry, then every firm in the industry prospers. In fact, research into distribution profitability indicates that the single most important reason why some industries produce higher profits than others are such industry-wide barriers.1

The reality is that distribution firms can’t unilaterally create industry-wide barriers to entry for their line of trade. Instead, they must find a way to erect their own unique barriers to entry at the individual firm level. Such barriers are much more fragile than industry-wide legal or licensing barriers. However, they also are much easier to construct.

Examples of company-specific barriers to entry abound in distribution, although they are not often thought of as such. A few selected examples include:

• Proprietary Technology—Ordering systems that link customers and distributors, particularly in an automatic reordering mode.

• Patronage Programs—Cumulative rebate programs that tend to tie customers to the firm.

• Tailored Assortments—Programs that facilitate one-stop shopping. These are particularly effective in industries where competitors are dramatically reducing inventory for cash flow reasons.

• Operational Effectiveness—Differentially high fill rates and differentially low error rates that lower operating costs for customers. Measuring the impact of barriers to entry is difficult when relying exclusively on available financial information. An analysis of profitability information from DPR reports conducted in forty different lines of trade in distribution suggests three benefits (1) an enhanced gross margin, probably in the range of one to two percentage points above the industry norm, (2) five to ten percent in additional sales volume, and (3) a reduction in payroll of between one-half and one percentage point.

It should be noted carefully that every line of trade is unique and that such differences play out differently among the various lines of trade. Financial results from the DPR report suggest that SEDA members appear to follow a pattern very close to the norm.

Exhibit 2 measures the profit impact of potential changes in performance for the typical SEDA member. A typical firm, producing pre-tax profits of $30,000, has the opportunity to increase profits by $255,100 or 850.3% if all three of the profit enhancement opportunities were realized fully.

The changes don’t impact results slightly. They move the firm into a different sphere of profitability. For all practical purposes the firm is no longer even in the same industry. If barriers to entry can be thought of as manageable defenses rather than an industry-wide condition over which the firm has no control, there is no real limit to the profitability levels that can be achieved.

De-Commoditization of the Product Line

Firms in nearly every industry feel that their products are, or are rapidly becoming, commodities. This simply is not the case. The product offer for SEDA members is diverse with numerous opportunities to avoid direct competition. Even if the most basic SKUs are commodities, there are always some extended product offerings to wrap around the commodity base.

The level of commoditization is second only to barriers to entry as a strategic determinant of profit in distribution. Interestingly, firms in the same industry often have very different views about the extent to which they sell commodities. Part of this is reality, but a large part is perception.

The distinction between commodities and non-commodities is important in that it produces a mind set in the firm about the role of pricing. With true commodities, the natural feeling is that there is little that can be done in the pricing arena. When the market price declines, firms must meet that price. If not, they are symbolically waving a flag indicating that their price on every item is high.

Non-commodities call for a very different set of rules. On these items there is the perception that there is some breathing room on price. The items may still be price sensitive to a large degree, but there is no requirement to meet every competitive price in every instance.

If one firm in the industry has a perception that virtually everything is a commodity while another feels that only a few items are commodities, then the two firms come to very different positions regarding pricing and gross margin.

Exhibit 3 presents the different perceptions graphically. The chart measures the gross margin “hit” the firm will experience if its prices on commodities are forced down from 2% to 10%. Each of the lines on the graph represents a different assumption about the role of commodities in the firm. The vertical axis represents the gross margin percentage produced by the firm.

For all five scenarios the graph starts at 26.2%, which is the margin enjoyed by the typical SEDA member. Obviously, different firms with different levels of commodities in their mix will have different gross margins. The 26.2% figure is used for all firms so that the impact of changes can be seen more clearly.

As the graph moves to the right on the horizontal axis, prices on commodities are lowered anywhere from 2% to 10%. The five lines, with dramatically different slopes, represent different mixes of commodities. The very top line is for a firm with no commodities at all in the product mix. The line is flat. If the firm has no commodities, then there are no price reductions. Consequently, there is no impact on the firm’s gross margin.

Conversely, the steepest line assumes that commodities represent 50% of the firm’s product mix. As the prices on those commodities are reduced, gross margin falls rapidly as half of the product line is under price pressure. Simply put, the greater the role that commodities play in the overall mix, the more rapidly price reductions drive down the firm’s total gross margin.

At the very far right of the graph, the firm with 10% of its mix in commodities has experienced a decline in overall gross margin from 26.2% to 19.1% when prices on the commodities are forced down by 10.0%. It is a decline that hurts, but it is manageable. However, for firms with 50.0% of their mix in commodities, the same 10.0% price reduction lowers overall gross margin to 15.5%. This represents an additional 3.6 percentage point loss in gross margin, all attributable to the mix of commodities that the firm’s staff “thinks” it has.

It can be argued that the mix of commodities is dictated by the nature of the industry, regardless of the firm’s actions. In practice, the firm has tremendous control over the actual mix. Part of the control comes from meticulous assortment planning and sales emphasis. A larger part, though, is based on the ability of the firm to distinguish between pure commodities and those that are not. It is a crucial distinction.

Ideally, SEDA members should be able to limit pure commodities to no more than ten percent of dollar sales. Probably another fifty percent of sales will come from items that are somewhat price sensitive. For this category, though, price is not the only value added. Therefore, margins are not whip-sawed by daily competitive activity.

The remaining forty percent of sales represent true margin-enhancement opportunities. On these slower selling items, availability at the time of need is the real value added. This is true even in commodity driven industries. If the ten percent pure commodity goal can be reached, margin and profits can be maintained at desired levels. If not, both are subject to the whims of competition.

Employee Productivity

Over the last few years, employee costs have become the name of the game in distribution. Direct payroll costs have risen steadily and fringe benefit costs have literally exploded. As only one indicator, monthly health insurance premiums for the typical distribution organization increased from $450 per employee in 1999 to $756 in 2003.2

The best overall measure of employee productivity and expense is what is called the Personnel Productivity Ratio, or the PPR. The PPR measures the percentage of each gross margin dollar that must be devoted to payroll (including fringe benefits). The calculation is simply fully loaded payroll costs divided by gross margin dollars.

For the typical SEDA member from Exhibit 1, the calculation of the PPR is:

Payroll Costs

Gross Margin

=

$1,637,500

$2,620,000

=

62.5%

This means that for every one dollar of gross margin that is generated, the firm must spend 62.5 cents on payroll. The figure is too high for long-term financial success.

Exhibit 4 graphs the dollar profits the firm will generate as it begins to lower its PPR. As can be seen, the relationship is quite pronounced. If, for example the firm could make a ten point reduction in the PPR, then dollar profits would increase from the current $30,000 to $292,000.

A ten point cut is dramatic. However, the high-profit firms within SEDA operate on a PPR of only 54.5%, compared to 62.5% for the typical firm. A program to move systematically towards the high-profit number is essential. In trying to improve the PPR, firms have three distinct opportunities:

• Actual Cost Levels—The amount spent per employee on payroll and fringe benefits.

• Productivity—The amount of output that is generated per unit of labor input.

• Workload—The number of orders, deliveries, invoices and the like that must be processed.

Historically, firms have focused almost exclusively on the first two—costs and productivity. As a result, efforts in these areas have reached a point of diminishing (or possibly even no) returns.

Cost reductions continue to be an important strategy for firms that can engage in outsourcing. However, most distribution functions have to be performed locally. In current parlance, it is hard to move the truck-driving function to India. While distribution firms are blocked on lowering payroll costs, they face an almost impossible battle on fringe benefits. Firms have engaged in some rearguard programs such as increasing co-pays and deductibles on health insurance. The best that can be hoped for, though, is to reduce the rate of increase.

Enhanced productivity has been the focal point of distributor activity in recent years. Inevitably, this has lead to increasing sophistication in terms of technology and operating systems. The use of technology to drive higher levels of productivity has been the great success of distribution. At the same time, the impact on the bottom line has been infuriatingly small.

The vast majority of employee-productivity technology has been industry wide. That is, new technology thrusts, such as bar coding and increasingly, radio frequency identification, ultimately are widely adopted by almost all distributors. The result is that costs go down for everybody.

If the story ended there, it would represent the proverbial happy ending. Unfortunately, as costs go down for everybody, gross margins also tend to go down for everybody. This leaves SEDA members more productive, but not more profitable.

It is probably time for distributors to turn their attention to controlling the workload. That is, they must manage the number of orders received, the number of deliveries made and the like.

For most managers, even thinking about workload controls is anathema. Distribution firms have built their entire business around service. If anything, though, distributors are now over-servicing their customers. The cost implication is clearly negative for distributors. Of strategic consequence, the cost implication is also negative for customers who waste their own employee time by placing and processing too many small orders.

Controlling the workload involves a combination of better analysis of costs and more sophisticated selling:

• Analysis—Before excessive activity can be eliminated, it must be identified. Activity Based Costing tools are now cheap enough (with Excel or other spreadsheets) that every firm should know its costs to process an order or make a delivery. The cost-understanding issue is no longer a barrier.

• Selling—Understanding is different than taking action. Programs must be in place to educate the sales force, and ultimately customers, on the essential need for fewer, larger orders throughout the channel.

Profit Focus

To accuse distributors of not having a profit focus is to accuse them of being un- American. The reality, though, is that most firms do not focus on profits with the absolute intensity that they should.

A true profit focus in distribution means two things. First, every operating division within the firm starts the year with a clear understanding of how much profit it should generate. Second, key decision makers are compensated upon their ability to help the division reach that goal.

Profit Understanding

Most SEDA members don’t really develop a profit-based financial plan. In fact, a large number of firms don’t even plan at all. They simply buy things and sell things and hope it all works out. For firms that do plan, the overwhelming majority of them focus on sales.

Sales would seem to be a natural starting point in planning. To really reach high profit performance, though, firms should engage in what is commonly called profit-first planning. That is, they should begin the year by determining how much profit the firm (or branch or division) is going to earn.

Exhibit 5 demonstrates how profit-first planning would work for the typical SEDA member. The exhibit starts with two simple pieces of information—profit before taxes and total assets. In step three the firm simply calculates its return on assets.

The real key in Exhibit 5 is in steps four and five which involves setting an ROA target. The exhibit suggests improving ROA by two to three percentage points in a single year. This goal is designed to force the firm to stretch without setting an unattainable goal.

As can be seen in the last step, if firms follow this approach they will be targeting a significant increase in profit performance. Such a goal provides a clear target for the coming year. This doesn’t guarantee success, but it does guarantee awareness of where the firm should be. It may appear to be a completely backwards approach. However, only such a profit-first approach can put a clear profit target in mind. Only then can the firm make the changes necessary to reach that goal.

Incentive Compensation

Even when firms set specific goals based upon profit, there is not always a commitment to the profit process. The latest distribution compensation report suggests that firms often pay bonuses on factors other than performance.3

For example, fully twenty percent of firms pay bonuses to the branch manager in a totally discretionary manner. In addition, another thirty percent pay bonuses based upon sales and gross margin generation. There is no clear link to profit before taxes or return on assets.

Until firms take a very decisive approach to incentive compensation based upon profit performance, the compensation package really emphasizes the wrong things. It is simply a way of deferring salaries until the end of the year. It does not reinforce desired performance.

Internal Profit Understanding

Upper management attends SEDA conventions. As a consequence, they are exposed to information on what drives profit and what does not. Meanwhile, back at the shop, second-tier managers, sales people and other decision makers have only a partial understanding of profitability. In fact, much of what they know about profit is actually wrong.

Exhibit 6 has been used by Profit Planning Group in convention presentations for years. It measures the impact of a one percent improvement in six key areas of the business. As an illustration, the first line indicates that there is a 3.2% increase in dollar profits for the typical SEDA member from raising prices by one percent. At the bottom, there is only a 3.1% profit improvement by lowering accounts receivable by one percent.

Given the widespread discussion of this exhibit and similar ones at conventions, it is not surprising that top management has a clear understanding of the exhibit and its implications. At the next level down in the firm, though, the perceptions are often woefully incorrect.

The numbers at the right of the exhibit with the strange sequence represent the ranking of importance that operating employees typically attribute to the factors. It should be noted that these rankings are not SEDA-specific, but represent a large number of distribution lines of trade. However, managers in SEDA businesses would probably have about the same sense of priorities. As can be seen, most second-tier managers feel that inventory is the most important factor in driving profitability while pricing is only sixth. There is a pronounced disconnect between perception and reality.

Closing the perception gap requires a strong commitment on the part of management to train key managers, sales reps and even some administrative employees on the realities of profitability. It is not enough to “show ‘em this chart” and hope for the best. Key employees must understand how their actions impact profitability and why. Only an on-going commitment to training can achieve the results desired.

Engineering the Future

The profit gap in distribution is not going to go away. Recall Exhibit 1 where the two SEDA members with the exactly the same sales volume of $10,000,000 produced either $30,000 or $360,000 in profits. The difference puts them into different worlds of performance. It also gives them two very different sets of prospects for the future. Quite literally, each firm will make the choice for itself. Some firms will make the changes required and will prosper. Others will conduct business as usual and may face challenges to survival.

___

1 Improving Distributor Profitability, National Association of Wholesaler-Distributors, Washington, DC, 2001.

2 2004 Employee Compensation Report, Profit Planning Group, Boulder, Colorado, 2004.

3 Ibid