of the accounts below is better for the long term value of a wholesale firm?
A-Sales $1.2MM, Margins $350,000, GM% 29%
B-Sales $950,000, Margins $250,000, GM% 26%
obvious answer is A. Right!? Anyone with any experience in wholesaling would
know this. The answer is simple, isn’t it?
again at the question. It asks about “long-term value.” What is long-term value?
For all intents, it’s what the shareholders could sell the company for, because
value has to be tangible and selling a distribution firm entails a view of the long-term
financials. Additionally, the best sale prices are achieved by pretax earnings
that are substantially above industry averages.
the following costs to serve the two accounts.
to serve are simply operating expenses allocated to the account. Why allocate
operating expenses? We are talking about long-term value which, based on the
allocations, gives Account A a net loss of ($64,000) and Account B a profit of
$40,000. Hence the contribution of Account B to pretax earnings is positive
while that of Account A is a big drag on earnings. In other words, Account B
enhances long-term value while Account A destroys it.
if our wholesale firm compensated outside sellers on straight commission margin
dollars to the tune of 15%. In this case, the seller for account A would get
$52,500 while Account B would generate $37,500.
the picture gets really interesting. If Account A loses $64,000, then why pay
the outside seller $52,500 to call on the account? Similarly, if Account B
earns $40,000, why pay the outside seller $37,500 to service the account? With
both accounts, the outside seller earns income whether there is an operating
loss on the account or more in compensation dollars than the firm earns in net
profit on the account. But this is just an example and this really doesn’t
happen in distribution – or does it?
if I told you that it happens, on average, over 40% of the time!
That’s right, over 40% of
sales territories fail to produce a contribution to operating profit, but
sellers get paid on the margin dollars produced. Another 25% of accounts fail to produce a profit that is acceptable for the capital investment of the shareholders. The disconnect is in the way
compensation programs work and how the firm makes profit.
Measuring vs. Counting
most of its 100-year+ history, distributors have driven the profit in their
firms by metrics and comparisons from the income statement. Gross margin
dollars, gross margin percent, top line sales, and operating expenses are
captured in time periods and benchmarked versus prior time periods. In many
industry associations, PAR reports capture data from wholesaler members where
the incoming data is disguised, aggregated and normalized. This allows
distributors to further compare operating data.
problem with the comparisons is that they are based on counting and not
measuring. In short, financial accounting compiles or counts transactions
within time periods of months, quarters, years, etc. But counting is not
measuring and, as in the preceding example, there are many instances where,
with proper allocations, gains become losses.
drive long-term value, wholesalers should focus on earnings and what customers,
transactions, sellers, and segments contribute to earnings. Financial
accounting gives wholesalers insights into various expense categories and returns
on assets. Assets are primarily inventory but financial accounting treats
inventory sold to customers as the same and gives no insight into the operating
profit contribution of a marketing or sales investment. Hence, a reasonable
method is needed to allocate cost to expenses related to marketing and sales
entities to understand how those entities contribute to operating profit. We
have chosen transaction types to develop allocations as exhibited below for the
an allocation methodology, we follow the rules suggested by Robert Kaplan of
the Harvard Business School
that the logic must be a single allocation method (baseline) logic and be consistent
throughout the firm. The logic also must be understood and actionable by the
firm. Hence we use transaction types as
methods of allocation.
work is called Labor Differential Transaction Management
(LDTM) and our
findings, when allocating costs to accounts is that financial accounting
metrics such as gross margin dollars and gross margin percents are crude means
to drive profits and long-term value for the wholesale firm.
In the example above, the
firm rewards the seller without any acceptable rewards, in the form of earnings, for the
shareholders. Furthermore, we find than any substantial compensation on margin
dollars has a very low correlation with earnings. Without allocating expenses
to accounts on their costs to serve, wholesalers literally throw away profits
on margin dollar rewards. In a thin operating margin business like wholesaling,
the practice is madness.
Moving Toward Better Compensation and Profit Measures
working with LDTM in the field for four years, our advice to wholesalers is to
understand that any compensation plan for sellers and with a strong component
of margin dollar rewards, is nearly as likely to decrease earnings as it is to
increase them. It doesn’t matter if the compensation is salary and bonus,
salary and commission, or straight commission; the use of margin dollars as a
financial reward has nothing much to do with whether or not the margin dollars
flow to earnings.
consume operating expenses at different rates and this consumption is driven by
the size of the individual transaction in margin dollars, the type of the
transaction and its cost, and the mix of transactions. Wholesalers need to
learn to link compensation to the ability of the individual account to contribute
to operating profit. Without this understanding, wholesalers throw away profit
and destroy long-term value in their compensation systems. Our advice based on
our consulting work is for wholesaler leaders to consider the following steps to
rectify this issue:
Develop a meaningful allocation method of operating expenses to customers and to
understand their contributions to operating profit.
Use an allocation methodology that has a single full-firm logic, is understood
in the lexicon of the industry and is actionable.
Thoroughly understand the allocations and methodology.
Reward sellers on their territories’ contribution to operating profit once
costs to serve have been allocated.
is an industry that adds considerable value to the North American economy. Destroying
this value by the use of period-based financial accounting measurements and
their design into compensation systems is throwing away money in a historically
thin margin environment and destroys long-term value.