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Driving Lower Profits by Compensating on Margin Dollars

October 20, 2008
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In the quest to increase profits, distributors have assumed for several decades that rewarding all or part of sales compensation on margin dollars equates to higher pretax income. However, our consulting work finds that margin dollar-based compensation programs have a 30% to 50% chance of creating negative profits. The reason(s) for this comes from common misunderstandings of how profit is generated and, until recently, the lack of knowledge to identify and correct the situation. 

Profit Making is Not Linear

For too long, distributors have regarded profit making as a linear exercise. The mindset comes from a simplistic understanding of profit as outlined in the income statement. Profit making, according to the statement of income, involves sales, margin dollars, margin percent and expenses. While this understanding is correct, it lacks fundamental details that don’t give critical insight into what really drives profit making in distribution.

Some years back, Activity Costing was a popular subject in distributed markets. The discipline allocated operating expenses to activities and rolled these activities up to customers, sales territories, etc. The problems with Activity Costing were many including complexity, questionable allocation methods, and spreading fixed costs over volume. 

Many of the complaints against Activity Costing were validated several years ago when Robert Kaplan of Harvard Business School and a protagonist of the discipline began to recant some of the original assumptions and methodologies. Our proprietary work in Activity Costing found that the key measures of the discipline including concentrating on Average Order Value had no meaningful correlation to increased profits. However, Activity Costing did attempt a very important task, which was to associate costs with customers and sellers.  

Several years ago, we began a move away from Activity Costing and began an earnest search for a better way to attach costs to customers, sellers, etc. Our focus centered on the transaction and not any transaction, but the handful of transactions that most wholesalers use including stock (original order), stock transfer, non-stock, drop-shipment, counter sales and back orders. We developed two disciplines from the work including Differential Costing and Transaction Management.1  

Differential Costing develops cost profiles for each transaction type and Transaction Management is the implementation of information generated from differential costs. Our findings from this work, including implementing them in the field, finds that of the basic transaction types, only two make any substantial profit for the firm. Stock sales above breakeven and direct shipments account, on average, for 58% of sales and 127% of operating profits. In essence, most of the other transaction types (stock transfer, non-stock, counter sales, and back-orders) lose money or make little money. The realization of the contribution of various transactions, to us, is profound.

First, much of what distribution does is not profitable. Second, the transactions distributors add the most value to including stock transfer, non-stock, and back orders, fail to generate enough margin dollars to cover their costs. In essence, distribution is what we term an “upside down” business model in that where the most value is added, the least profits are generated. Finally, unless one understands (in detail) Differential Costs and Transaction Management, they will not understand how to effectively, efficiently, and strategically fix the low profit woes that accompany some two-thirds of distributors. One of the prime examples of not understanding how transaction costs influence profitability is in the insistence on rewarding sellers on margin dollars which, as we have previously stated, has a 30% to 50% chance of yielding territories that generate negative operating profits.

The Drivers of Profit and Conflict with Margin Dollar Compensation

Transaction profit, which is the result of margin dollars less transaction costs, closely approximates operating profit from the income statement. In several years of running Differential Costing analyses for distributors, we find that transaction profit is driven by three variables including transaction size in margin dollars, type and cost of transaction, and the mix of transactions. These concepts are illustrated here:
Pillars of Transaction Profit
2
The Three Drivers of Transaction Profitability:
  • Transaction Size in Margin Dollars
  • Transaction Type and Cost
  • Transaction Mix


  • In essence, it is not enough to target margin dollars as a component of compensation in hopes that they will drive operating income. Margin dollars mean little without their associated costs. And the transaction size, type of transaction and its costs, and transaction mix are essential parts of any profitability analysis and management. These measurements complement margin dollars and can be attached to accounts and summed by territories to understand if individual sellers are generating operating income.

    As we compile transaction profitability by territory, there is, on average, a 30% to 50% probability that compensation on margin dollars will yield negative transaction profits. In essence, the accounts in the territory cost more to serve than they generate in margin dollars. The problem with margin dollar compensation is that margin dollars cause the seller to bring in any transaction type, any customer, and oftentimes at any pricing level. 

    For distributors to correct this situation, the first place to start is to develop a compensation system based on transaction profits and quickly following this up with training, programs, and events on how to increase transaction profits or, at the least, decrease transaction losses. Key events to stanch losses include pricing by transaction type and size, minimum transaction sizes, transaction shifting, and product and transaction bundling. These efforts and others can have a profound effect on profits. Without them, many wholesalers are investing six figures and more into sellers who have a high probability of costing the company bottom line profits. 

    In short, wholesalers are pumping $100,000 into sellers who have a high probability of losing beaucoup dollars for that are far in excess of their sales compensation. In a recent Transaction Audit, we found a sizable wholesaler who had half of the sales territories that were transaction profit negative. They compensated sellers on a fixed percent of territory margin dollars and the losses from the territories exceeded the compensation costs for those territories by a factor of 3x. Our comment was that by simply switching to a transaction profit-based compensation and without further training and rules on fixing negative transactions, half of the sales force would need to pay them (the wholesaler) to work there.

    Our warning and entreaty in this installment is that wholesalers who pay their sellers on margin dollars (straight commission, base and bonus, etc.) will likely be disappointed with their earnings and a large part of the culprit is the compensation system. Margin dollar compensation without the associated costs of transactions doesn’t mean much and rewarding sellers with simple margin dollar-based plans is a bad idea that conflicts with profit making.

    1Differential Costing and Transaction Management are trademarks of Benfield Consulting and Merrimont Consulting. 
    2Three Drivers of Transaction Profitability, is copyright of Benfield Consulting in the upcoming book, Driving Transaction Profits.


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