In
his recent book,
Profit Myths in
Wholesale Distribution, Al Bates lauds gross margin dollars as
one of the most important numbers and concepts in running a profitable
wholesale company. From a financial accounting perspective, where numbers are
compiled in time periods, he is correct. If you don’t have enough margin
dollars to float the bills and provide a reasonable profit, the business is not
worth much. From a long-term perspective, however, and for managing profit at
the account, segment, branch or sales territory level, margin dollars leave a
lot to be desired.
The
problem with margin dollars is that they can’t, in the traditional format of
the income statement, tell distributors much about which accounts, territories
and even in some cases branches contribute to operating profits. Recently,
there has been a resurgence of interest in understanding which accounts,
territories, etc., contribute to operating profits and which don’t. The nascent
field has produced certain sound bites and terms that will become an enduring
part of the distributor lexicon.
One
of these terms, “cost to serve,” is getting air time with popular consultants. We
began using the term back in 2004 with our seminars on cost management for
various associations. In truth, there are articles, specific to wholesalers,
citing service costs dating back to 1984.
The
primary issue with cost to serve is that the wholesale firm must have some type
of method to allocate costs to accounts and other marketing and sales entities.
Activity costing was the preferred model some years back but user interest has
waned due to complexity and questionable information.
There
are, as of today, two methods for allocation that avoid the complexity of
yesteryear and adhere to the new rules of allocation:
1) a
single baseline logic; and
2) applicable to the wholesale
industry and easy to use. These models are Time Based Activity Costing offered
by Acorn Systems and Differential Transaction Costing by Benfield Consulting. Other
costing methodologies often fail the two rules cited above, invented by Robert
Kaplan.
(For
more on the differences in cost-to-serve models and myths, see our online
article at:
http://www.industrialsupplymagazine.com/pages/Management---Five-myths.php)
Assuming the distributor has a valid cost
allocation logic, the challenge becomes how to manage the information. One of
the popular lines is that giving outside sellers a load of cost-to-serve
statistics, and changing sales compensation to reward cost-to-serve profits, is
the way to profitable accounts. Our work in Differential Transaction Costing
Management finds that giving outside sellers cost-to-serve statistics and
changing their compensation to reward on cost-to-serve profits is, generally, a
bad idea.
Managing and Planning vs. A Bunch of Numbers
Our
research and history show that traditional compensation models that reward heavily
on margin dollars are, largely, a bust.
Why?
Valid cost-to-serve models find that some 40% of sales territories are profit
negative. In essence, gross margin dollars don’t include cost-to-serve analyses
and hence, the number is a crude tool in managing operating profit. And, it
really doesn’t matter whether the compensation system is bonus and salary,
commission and salary, straight commission, or some hybrid combination
structure.
As long as the
system uses margin dollars to determine a significant part of compensation, the
result is that there is scant correlation between this measurement and
operating profits at the territory and account level. Enterprising
knowledge brokers have tapped into this fact and have come up with new
cost-to-serve models and services. These are quick to recommend changes to
compensation and sellers being brought up to speed on cost-to-serve statistics
and strategies. In our opinion, distribution is an industry inebriated with
sales solutions. New methods based on sales to fix profitability amounts to
passing the bottle to the habitual drinker.
We
have seen sales-driven tactics include pricing so complex and incoherent that
it rendered the cure worse than the disease. We have seen customized service
solutions that caused operating costs to balloon and service errors to
rise.
Our
work finds that changes to compensation using cost-to-serve statistics and
giving sellers new numbers is largely ineffective for profit solutions unless
they are preceded by proper planning in marketing and operations
before sellers are given a
bunch of numbers.
Common
solutions that we recommend to clients where cost-to-serve numbers are negative
include segmented pricing, service rationalization, fee-based services, and
streamlining services.
In
essence, when engaging cost-to-serve logic, it behooves management to develop
pricing, services, and cost restructuring prior to rolling out any of the data
to sellers. Properly developed and vetted solutions at the corporate level prevent
sellers from offering customized solutions that, too often, cause operating
costs and errors to rise, which defeats the purpose of engaging the discipline
in the first place.
Our
advice before engaging any cost-to-serve logic is to research the literature
and ask the following questions:
1) Does the cost-to-serve allocation logic adhere to the
principles set out in Kaplan’s research, i.e., one baseline logic and easy to
use in the terminology of the business?
2)
Does your firm have the proper understanding and ability to plan solutions
around operations and pricing at the segment level?
3)
Does your firm have the proper controls and review process to implement common
cost-to-serve solutions?
If
you can’t answer or don’t understand why these questions are important, we
suggest not getting involved in the new knowledge. Otherwise, we are confident
that you will be easy targets for costing models that don’t work, and you will
end up disappointed and disillusioned.
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