The path to value in PHCP distribution
The use of value in management is mostly as a concept and often found in the statement(s) value added or value chain. Wholesalers add value in their services surrounding the products they distribute and as exemplified in the classic service cycle of purchasing, receiving, picking, sales, shipping, payment, credit, warranties and returns.
Within the last decade, however, there has been a growing body of knowledge that measures tangible value and relates it to the market price of the firm. This research has been done in the public markets where data is available and linked to the share price and market capitalization of the going concern.
The output of the logic, as it affects supply chain entities, including wholesalers, is that measuring value is the single best way for wholesaler owner/operators to improve financial returns. Value far and away is superior to focusing on operating profits and variants of earnings or net profit before tax (NPBT).
The issue with value, in supply chain firms, is that service value is the relevant entity under production and worthy of measure. Service value, however, is found in the operating expenses of the income statement. Hence, operating profits have to be assigned or allocated for insight into where value is generated. Too, value is the primary product of two entities: returns and growth. The measure of Return on Invested Capital or (ROIC) needs to be gathered for each investment and where ensuing returns for discrete value are evaluated for their attractiveness and future growth.
The problem with value, for distributors, is that the measures and management process for value generation and creation don’t exist. Distributors overwhelmingly use financial accounting data for management of future value and, in the process, tend to destroy value as fast as they generate it. Our research over the past five years has been to help distributors use new measures with new knowledge of where value exists, what to do about it and how to increase the market value of the wholesale firm.
Fundamentals of valueValue is defined as ROIC of individual investments and the growth prospects of said investments. Distributors invest service labor in fulfilling transactions and investments can be measured by individual transaction, customer, sales territory, market segment and marketing program. Distributors must consider that these entities are investments and the ROIC must be measured specific to the investment to be confident it produces value.
The allocation of operating expenses to investments has been around wholesaling circles for two decades. The predominant problem in allocating expenses is that many allocation models don’t give an accurate picture of how labor is consumed by the investment. In 2006, Robert Kaplan of the Harvard Business School and inventor of Activity Costing in the 1980s, developed new standards for cost allocations including the ability to accurately measure labor capacity, usage of terminology that is actionable in the industry and use of a singular baseline logic.
At Benfield Consulting, we follow Kaplan’s standards and start with base transactions of stock, non-stock transfer, non-stock special, drop ship, counter or retail and rep order. Our work with the model, over the past five years, finds that transaction type is an accurate and actionable singular logic on which to allocate costs. The labor for individual transactions differs and we add components of outside sales coverage or not covered, inside sales entered or e-commerce, shipped to customer or pick up at branch, etc., to each base transaction ending up with 12 to 20+ transaction types for the typical wholesaler.[i] We allocate all costs that have to do with fulfilling the transaction and typically leave out fixed costs of branch overhead and executive salaries.
For all intents and purposes, approximately 80% of the allocated costs represent labor used by the wholesale firm. The explanation of allocation logic is important as we continue to find where the predominance of existing allocation models doesn’t follow Kaplan’s standards and, hence, these models are not recommended for measuring value.
We continue to find outdated and inaccurate concepts such as Average Order Size and Average Order Cost used in certain models. Our work in the costing of transaction types finds that there are significant variations in transaction costs, often exceeding $100, and using the concept of “average” in measuring value is best described by the metaphor, “An average person has one breast and one testicle.”[ii]
The Value Equation, once allocations have been measured, is: Capital Returns/Capital Investments, expressed as a percent and less than the weighted average cost of capital. For example, Bayou Plumbing Wholesaler has as an account, Thibideaux Gator Processing, with purchases of $189,663, margins of $38,829 and margin percent of 21%. These figures are secured from the financial statements of the wholesaler and while of some importance, they don’t come close to measuring value.
Bayou Plumbing, after developing a transaction-based costing model, finds that the cost to serve is $36,110, which leaves $2,719 ($38,829-$36,110) in transaction profits. The concentration on transaction profits of $2,719, or transaction profits as a percent of sales at 1.4%, has no meaningful correlation to the value producing ability of the account.
Returning to our definition of Capital Returns/Capital Investment, the ROIC of Thibideaux is $2,719/$36,110 or 7.5%. If the weighted average cost of capital for Bayou Plumbing is 8.5%, then the account destroys value by 1%. Hence, to accurately measure the ROIC on an investment, wholesalers need to create two new measures, which are not found in financial accounting with a modern-day cost allocation logic and this must be compared to the weighted average cost of capital for insight.
Using value for improving the value of the wholesale firmMany wholesalers don’t measure the weighted average cost of capital and consider the measure of limited use. While we find this position in need of change, we accommodate clients by referring to value investments with color codes of red, yellow and green as used in the common traffic signal.
Red Investments are some 40% of customers, transactions, sales territories, segments, etc., that have a negative value or a negative ROIC. We say they literally destroy value.
Yellow investments are typically 20% of investments that have an ROIC below the weighted average cost of capital. In essence, they yield a positive but low return.
Green investments are 40% of customers, transactions, sales territories, segments, etc., that have a positive ROIC above the weighted average cost of capital.
Many wholesalers, when measuring value, are too often “deer in the headlights” struck and fail to move toward a working logic on how to rectify the situation of investing in Red and Yellow entities. From our work, several quick and easy rules apply to improving value and they are included in the wrap-up of this blog entry.
Generating value in wholesale distributionTo create a higher than average ROIC and growth prospects in wholesale distribution, we recommend the following steps:
A value approach to managing wholesale firms takes the use of a modern-day cost allocation logic and usage of ROIC specific to common investments of transactions, sales territories, customers, segments and marketing programs. The field is new and offers significant hope where most wholesalers, using financial accounting, tend to destroy value almost as fast as they generate it and as evidenced by research that finds 50% to 60% of wholesale firms sell for asset value.
[i] Benfield Consulting’s transaction costing model is Labor Differential Transaction Costing and is filed in the US Patent Office with Patent Pending status.
[ii] Attributed to Des McHale, Assoc. Prof. of Mathematics at University College, Cork, Ireland.