The following blog is
taken from an upcoming book released by Benfield Consulting titled,
“Building Value: Driving Wholesaler Returns
through Strategic and Tactical Investment.”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 value
Value 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 firm
Many 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 distribution
To create a higher than average ROIC and growth
prospects in wholesale distribution, we recommend the following steps:
Don’t be stressed by Red investments
as a whole. There will always be negative value entities in the wholesale firm.
Instead, work to move service elements away from the sector or claw back value
by attaching service fees or minimums to service inputs.
Concentrate on the high Red (negative
value investments), Yellow investments and the low value end of Green
investments. This mid-range is where the most improvement can be made. Look to
limit over-investing, engage pricing and encourage moving to higher yielding
transactions of stock and drop shipments.
Look for new products,
new services for fees and new models to serve customers for superior value
creation. These are strategic means of creating and generating value whereas
most distributors spend time on tactical areas of value including selling
existing products to existing customers.
Don’t concern yourself with
differentiation between shareholder and customer value. These constructs, when
used in tandem, have no technical definitions that we can find and are not
actionable.
The best value research uses ROIC and investing in growth areas, specific to
the firm, as the best means to generate value. In essence, the companies that
produce the highest ROIC with the best growth provide value to themselves and
to their customers; hence, there is no measurable difference in shareholder and
customer value because good
shareholder value is good customer value.
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.Links
