Disintermediation Followed By a Side Order Of Cannibalization
Wholesale distribution is a slow-to-change business. A review of the current research should testify to the accuracy of the statement. In recent months, we have chronicled research in sales compensation at a time when all signs point to less need of sellers both inside and out. Much substantial change for the wholesale industry is brought in from the outside. Knowledge of modern inventory management, activity costing, customer profitability and capturing value with pricing all had their roots outside of the industry.
In fact, for knowledge that moves and shakes the staid old sector, it is hard to think of any managerial knowledge developed from inside the industry that does more than cause a few tremors and moves much faster than the mile high glaciers of the last Ice Age. Hence, we tend to look outside the industry at technologies and trends that converge and will have significant impact on the sector. In our study of value generation[i] (return on capital) for wholesaler investments in sellers, branches, customers, transactions, and vendors, the single greatest impact on the industry - in many a year - will be wrought by changes at work outside the industry.
The changes we are alluding to will be due to the convergence of three technologies specifically; e-commerce as a business strategy, globalization of supply and new models of transaction costing. The combinations of these events have a high probability of disintermediating the current one-size-fits-all service platform common to most wholesalers. And, once services are disintermediated, don’t be surprised if the wholesale firm will have to cannibalize part of their existing business to stay in business.
Three is the Magic NumberWhen it comes to big change, it is rare that a new and heretofore unknown technology(ies) drive an en-masse and quick change. In most instances, the pieces of big change have been around for some time. In the case of breaking apart the full service bundle, the biggest threat has been a complementary strategy for many years. E-commerce emerged, mostly, in the last decade and as a supporting technology for customers. Wholesalers were quick to realize the labor savings and increased accuracy of getting customers to order online. For all intents and purposes, e-commerce was stressed without little, if any, discounting to induce trial. But e-commerce and the greater subject of e-business has progressed in knowledge and acceptance in the last decade to where, recently, we visited a wholesaler who uses advanced analytics on incoming e-mail RFQ’s to increase the hit rate of their quotes.
Today it’s possible to solicit, quote and land an order using e-business. Furthermore, tomorrow’s generation of b2b buyers and sellers (now in their 20s and early 30s) will prefer using the Internet over the old belly to belly sales call.
The second piece of the big change puzzle is an accurate costing of transactions. In years past, wholesalers have used Activity costing or watered down models of cost allocation to help with investments in customers. Activity costing’s original models full of hundreds, if not thousands, of variables have long been abandoned. In their place were simplistic models that used concept(s) such as average order size. The knowledge of allocating costs swung from too much detail to way too little.
Precision to the nth degree was replaced by averaging all transactions into the variable of “average order size” which is, to us, insightful into nothing much. We use a proprietary costing logic that typically uses 12-18 transaction types. Each base transaction (stock, non-stock, direct, etc.) has components of outside sales or not, inside sales or e-commerce, delivered or customer pick up. The costing closely follows the consumption of labor by the transaction. For instance, variants on stock transactions could include:[i]
Outside Sales Assigned-Order Writer-Delivered-Cost $157
No Outside Sales Assigned-Order Writer-Delivered- Cost $77
- No Outside Sales Assigned-E-Commerce-Delivered-Cost $51
Transaction costs have proven to be highly accurate in our work of the past five years. And the logic, today, stands to become key in the move toward disintermediation.
The last bit of change will be wrought by global supply chains. We researched the move of wholesalers toward sourcing foreign off-brand items versus domestically designed but mostly foreign produced domestic brands back in 2008. Our finding then was that there was a 30% landed cost difference in securing off-brand purchases.
Today, while the acceptance and use of off-brands is greater than three years ago, we find a growing gap in wholesalers who chase low-cost manufacturing around the globe and those content to buy from domestic vendors. Wholesalers who have active global contacts in search of cost advantage will fare much better in the coming years than those who tend to keep tired and often overpriced brands produced by conglomerates. The manufacturing cost advantage is going to focused plants producing a few products well and wholesalers who follow these entities can have a significant advantage over the competition. Now that the three sources of change have been identified, all that is needed is the know-how and will to bring their advantages to market.
The Transactional Distributor Comes of AgeApproximately a decade ago, we began researching and writing about a new group of wholesalers called Transactional. In essence, these entities took a slice of the value chain, reduced services and offered a great price to the customer base. Many of the entities used e-commerce and had low-cost off brands. We dubbed them transactional because of their focus on the transaction. Today, combining off-brands with e-business and accurate costing, the stage is set for a low-cost model of business that is deadly to much of today’s full-service wholesaling.
To convince readers of the basics of how the transaction model works, consider the HVAC wholesaler, Rush Street Supply of Chicago. The company sells units to a dealer base and most have a shop inventory. Currently, the average full serve stock order (Sales Assigned, Order Writer, Delivered) is $500 at a 23% margin. The costs of a stock order are those exhibited earlier in the article. Since the cost of goods for the order is $408 and the cost is $157, the order loses ($42).
Rush Street’s management moves to change the dynamics of the business to their advantage. Management, using transaction costing, knows that the cost of an e-commerce order is $51 or $106 less than the full service variety. They also know, however, the customer won’t move to order online and handle any ordering hassles without financial motivation. Furthermore, they are convinced that they can increase the transaction size and get the customer to inventory more with a better price. The math and the ordering logic works like this:
order volumes are given at $1000, $1500 and $2000.
-Costs for each order using the full service model are: $314, $471 and $628.
-Costs for each order using the stripped down e-commerce order are: $102, $153 and $204.
-Pricing using the stripped down e-commerce order is set at a 17.5% gross margin on the $1000 order, 15% on the $1500 order and 12% on the $2000 order.
-Transaction profits (GM$-Transaction Cost) for each order size are: $73 for the $1000 order, $72 for the $1500 order and $36 for the $2000 order.
-Transaction ROI for each order is ($73/$102) or 73% for the $1000 order, ($72/$153) or 47% for the $1500 order and ($36/$204) or 18% for the $2000 order.
What you’ve just witnessed is an example of variable transaction size pricing and all it takes is a reasonably robust e-commerce model and an accurate modeling of transaction costs. Consider also, that Rush Street moves to buy 25% of their goods as off-brands and secure a 25% landed cost advantage. This makes the cost of goods of the current full service stock order $382. That’s approximately a $25 cost advantage which equates to a $50, $100 or $150 advantage on the $1000, $1500 and $2000 transaction.
Consider that Rush Street management passes on 50% of the cost advantage to the customer. For the $1500 order, the cost of goods moves from $1275 to approximately $1175 and the customer gets the goods for $1440 (($1175 + $50)/.85) which is an added 4% discount from the already 8% discount from regular pricing. In short, the customer, buying a $1500 order via e-commerce, sans sales support, and with 25% of the goods as off-brands would get a 12% discount over the current buying level. And the deal would get better the larger the transaction size and greater the use of off-brands.
The ability of the customer to garner significant savings using off-brands, transaction size pricing, and e-commerce is typically between 10% to 30% over the current full service, one-size-fits-all service model. The traditional model is rendered non-competitive and will have a hard time competing with the transactional offering. Why? The traditional model bundles up a significant amount of negative transactions and has to keep margins high on the profitable customers to pay for the unprofitable ones.
Structuring the business platform with accurate transaction costs gives the wholesaler a chance to make money on most orders and avoid losing ones. The model of business is structured to drive profitable transactions and this is a sea change from present practice. The existing full service model was formed using margin dollars as an incentive for sellers regardless of the service cost of the incoming margin dollars. Hence, the typical wholesaler platform is convoluted with significant losses on investments in transaction types, sellers, customers, etc. To make the model work, wholesalers have to charge the most profitable customers high prices to pay for the losing and low return parts of the business which is often 60% of customers, transactions, sales territories, etc.
Disintermediation and Cannibalization- Get Use to ItBundling all customers and services together and using an overall margin (in the case of Rush Street 23%) to cover all transactions, regardless of how they consume service costs, is a model of business that is in trouble. Technology of e-commerce, global supply chains and accurate transaction costs will unbundle (disintermediate) the one-size-fits-all platform. A certain amount of cannibalization will take place on existing accounts even if Rush Street creates a new business with a different e-commerce front, billing location, logo, etc.
The model is especially useful in dealer-based businesses where demand is easy to forecast and there is space to take larger orders. Too, repair businesses and MRO and OEM customers where bin space at the customer site is used can also participate in the new model.
The wholesaler who launches the model will be braving new territory in most vertical markets as transactional distributors are relatively small in number, but we expect their presence to grow and become more mainstream. Many Generation X and most of Generation Y buyers of wholesaler products and services will prefer to conduct relationships online. They don’t expect a lot of sales support and, in many instances, don’t want it on commodity purchases. Too, it is entirely possible for wholesalers who engage transactional distribution to perform it with smaller branch footprints and much less in the way of bricks and mortar. The inventory strategy will, from our experience, target the high volume A and B items to drive order size. C and D items and specialty orders won’t be a part of the service.
Those who doubt the viability of a transactional strategy should consider Southwest Airlines and Aldi Markets. These companies are some of the fastest growing, most profitable, and least cost to the customer entities in their respective industries. Traditional wholesalers, in love with their one-size-fits-all model, often scoff at the idea of transactional distribution and the economics that accompany it. They point to the value added of their full sales forces and branch management staff. Unfortunately, they greatly underestimate the desire of the customer for a reduced price who, when they know what they want to buy, are perfectly content to purchase it online with limited support.
When we’ve uncovered transactional strategies in our consulting, it is usually the bane of a full service distributor who decries a “price prostitute” in the marketplace. What they don’t realize, and often can’t come to terms with, is that they’ve been upended by a new model of commerce that is more cost effective, with a smaller footprint, and more accurate than their sales driven “get any margin dollar that’s out there” business. In all cases where the transactional model takes hold, we’ve yet to see the traditional wholesaler gain back much, if any, of the lost revenue.
i Blog post excerpted from an upcoming Benfield Consulting book, “Building Value: Driving Wholesaler Returns through Strategic and Tactical Investment.” 2011 All rights reserved.
ii Costs based on Benfield Consulting transaction cost modeling 2006-2011.