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Compensate This

July 5, 2011
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In this third year of my blog for Supply House Times, it is time for my annual rant against some nonsensical or non-value added practice in distribution.  

In this third year of my blog for Supply House Times, it is time for my annual rant against some nonsensical or non-value added practice in distribution. I’ve chosen sales compensation as a rant-worthy subject after recently witnessing precious research money spent on yet another compensation study.

I’ve reviewed compensation in previous issues as having nothing much to do with anything other than giving management something to feel good about when the new compensation plan is done.

Margin Dollar Mania

Most compensation is done around margin dollars specific to a territory. The problem with margin dollars as connected to an account and a territory is that they really have no correlation with the return on investment delivered by the account or territory. Margin dollars don’t determine the way operating costs or fulfillment labor is consumed, but transactions do. We model transactions and assign costs to them using a proprietary and patent-pending process and, after five years of work with the data, we typically find no meaningful statistical correlation between margin dollars at the account or territory level and return on sales of the account or territory.  In essence, you can’t look at the annual margin dollars or sales of an account or territory and predict if it is a good investment. 

For instance, some transaction types are perennially small or expensive to produce, such as counter sales or non-stock sales. If a territory is full of these types of transactions, it often consumes more in operating expenses for fulfilling orders than it delivers in margin dollars.

Over the years, various cost-to-serve models have warned distributors of the problem with margin dollars, including the generally accepted view that 40% of accounts are profitable, 20% make nominal profits, and 40% suck the cash right out of the organization. Undaunted, distributors pay sellers on margin dollars anyway and seem content to believe that some unseen miracle will deliver higher than average profits even when they pay their sellers to literally destroy value by not discriminating good from bad margin dollar customers and transactions.

Compensation Models-Phooey

Ostensibly, the new compensation research will target the best compensation models to drive financial performance. Our guess is that the enlightened will talk about a balanced compensation scheme that links margin dollars with some cost-to-serve metric to drive profitability. The problem with this thinking is that the solutions to cost-to-serve issues aren’t sales based. From our work, linking cost-to-serve metrics to seller compensation produces no substantial change in profitability. 

Solutions such as transaction size pricing, aligning service platforms to customer groups, profiling new accounts for transaction profitability, and strategic pricing by transaction economics are not subjects used by sellers. Selling is largely tactical and the previous solutions are strategic and have to be engaged by executive management to become a reality. Simply burdening sellers with cost-to-serve metrics only confuses them and doesn’t make profits better.

Whether the compensation model uses cost-to-serve metrics, margin dollars or a combination of these issues doesn’t matter to operating profit generation. The type of compensation plan whether salary and bonus, salary and commission, or straight commission, doesn’t matter when it comes to growing operating income. 

Compensation change and expected results is a perennial issue where sales managers and executives crowd seminars to come up with the best plan to drive profitability. Our charge to wholesalers, in the age of technology, cost-to-serve economics, slow growth and value-seeking customers is that compensation will mean even less in the future.

The Transactional Model

We’ve been studying a model of business called transactional distribution for more than a decade. The first successful model we witnessed was in Chicago and it opened our eyes to the new world and how, for many distributors, the future will be bleak unless they change. Transactional distributors, in a nutshell, seek cost advantage by rearranging or deleting redundant services and securing low-cost quality products. The model has a growing following because of the convergence of global manufacturing, cost-to-serve analytics, and acceptance of e-commerce.      

A transactional distributor works to get customers to place most or all orders through e-commerce. They source the lowest cost, best quality products from around the globe. Finally, they have an accurate understanding of transaction costs, using a valid cost-to serve-model that captures differences in individual transaction types and their effect on operating profit. The customer is then encouraged to place orders online, for low-cost products, and in transaction sizes and types where the distributor can offer a substantial price break and make more money than they can with historic sku pricing.

The results are staggering, including price breaks of 20% to 30% and return on sales in the double digits. The cost savings from the transaction model are the following:
  • Little or no selling (inside or outside) that comprises 30% to 50% of operating expenses;

  • Lower cost inventory than can be as much as 30% less on average than branded products;

  • Larger transactions that absorb costs at a faster rate than their fulfillment costs.

If distributor owners don’t believe that the traditional full service, sales intensive distributor can’t be successful without loads of sales staff, they should research the inputs of a transactional model, pull a few key customers aside and see if they would be happy ordering online for a 20% to 30% discount and forego the massive sales support inherent in the full-service offering. The issue for distributors is that the technology and know-how to build a low-cost model is here and the slow growth economy of the “new normal” has primed the pump. 

Recently, I found that the iPad has a Skype program that allows video conferencing. In my view, for a few hundred bucks, one can simply give the iPad to key accounts and cut back on the sales force. Oh, and I forgot one tidbit: There is no compensation issue in the transaction model. Why? There are few, if any, sellers to compensate!

As we have written many times and in many places, there is no need to spend massive funds on a sales effort where the bulk of the products are commodities and the customer knows what they want to buy. This doesn’t mean that selling is gone, but there will be significant paring in the function. The outside sales models that will survive include consultative, enterprise and application selling. The old-style route or trade seller, however, is largely gone, as is much of the inside sales, just-in-case position. 

Since seeing the transactional model in action for a decade, I can say that it is growing and the technology and knowledge is prescient for a new model of distribution to emerge in a big way. To help in the quest for the new knowledge, I’ll be publishing a new book in the Fall of 2011 that, among other subjects, delves into the model.  

In the future, compensation for sellers probably won’t be as thorny an issue as it is today. The wholesalers that survive will give a much better price for commodities that comprise some 70% of the business. Those that don’t follow this model will have to compete with a full service offering that, for us, is fraught with inefficiencies and old-style services that the b-to-b buyer doesn’t need. In the meantime, I’ll have to deal with research projects aimed at the past subjects but don’t speak to the future.

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