However, in today’s knowledge and reality, these concepts are obsolete and, often, bunk. The issue(s) at stake are far more than a new tidbit of knowledge. Getting past concepts such as margin dollars, margin percent, and top line sales as key metrics is a BIG change and implies significant and substantial change in the modus operandi of most wholesalers.
An explanation is in order and I’ll be succinct and, hopefully, thorough in explaining why the old standby measures and metrics are obsolete. The fundamental concepts at play in the new knowledge are operating costs of the wholesaler, how they move (behave) with sales volume, and how they determine operating profit. Wholesaling is, for the most part, an aggressive step cost business. This means operating expenses “step up” with sales volume. In essence, as more orders are processed, the wholesale firm needs more trucks, more warehousemen, more accounting clerks, more sellers, and more purchasers. These operations, more or less, rise closely with volume. Other costs including I/T, warehouse equipment, phone service, etc., rise with volume but often at a slower rate than labor for rote processes.
In all, my work finds that some 75% or so of operating expenses are step based. Ergo, when one measures an outside seller on margin dollars, none of the operating expenses that are incurred with the margin dollars are included in his/her territory. The result is that many sales territories and outside sellers are unprofitable because there is no matching of expenses with margin dollars. Similarly, first-level pricing analyses often look at margin percent without looking at costs of conducting the order and, again, the results are pricing recommendations that are way off the mark and not effective in the long run.
The summation of using metrics like margin dollars, sales, or margin percent is that they don’t really tell the wholesale manager and executive if their customers, sellers, branches, transactions, etc., are profitable since they don’t consider step costs.
To remedy the situation of allocating step costs to sales, there was a big push, some years back, for activity costing. The basic idea was to use activities and assign costs to them to get better insight into what was profitable and what was not, and what lost money on a consistent basis. Activity costing, however, died a slow death. Too many distributors that tried it found the expense, complexity, and assumptions prohibitive. I used a watered down version of Activity Costing in my consulting work for several years, but I increasingly became disenchanted with the logic.
About four years ago, I began to work on using transaction types as a cost allocation method. Transactions seemed a good fit; they were measured, well understood, and wholesalers generally agreed that different transactions have dramatically different processing costs. Ergo, I began to work on a means to model transaction costs in distribution and use the logic to understand where money was made or lost in the distributorship. Ironically, about this time, the originator of Activity Costing, Robert Kaplan of HBS, in a working paper, publicly recanted much of the activity costing work citing complexity, expense, and fallacious assumptions.
Today, my work with Transaction-based allocations is complete. I’ve worked the discipline in the field for several years. The information coming out of my work is rather startling including the observation(s):
- Forty percent of sellers don’t contribute
to operating profit. This is typically the result of rewarding sellers on
margin dollars as all or a substantial part of their income. Not all margin
dollars are the same and it is very common to find sellers who have lots of
margin dollars but negative profits.
- Many transaction types are unprofitable or low
profit. Counter sales, non-stock sales, and many branch transfers are
unprofitable and sap the operating capacity of the firm.
- Many satellite branches and pick-up branches
don’t make money. Their transaction size is too small and doesn’t cover many
processing costs supporting their orders.
- Transactions where the least value (defined as
operating cost) is added are the most profitable. In essence, some 120% of the
profit of the wholesale firm is with drop shipments and original stock orders. Other
more complex orders consistently lose money. (In essence, wholesalers lose
money where the most value is added!)
- Forty percent of customers produce 130% of operating profit. The other 60 percent of customers diminish operating profit.
The usefulness of this knowledge, at least to me and the clients that have used it is substantial. They are no longer guessing where and how they make and perpetuate profitability. They can target the customers, sellers, transactions, branches, and products where the money is made. And they can mitigate loss in money losing ventures with targeted pricing, streamlining processes, or eliminating the operation. It’s not unusual to have distributors who have doubled their profits with the information. And it would seem, at least to me, that the knowledge and the testimonials would have great interest where the average company earns 2%-3% of sales in pretax profits.
My dismay and disbelief comes with several months of focusing on the knowledge brokers and “luminaries” in the PHCCP channel about the subject matter and the findings. I have received little more than passing glances with not one substantial and well thought out argument as to why the knowledge and discipline is not valuable and needed. In recent months, I have witnessed seminars on sales compensation models with the key metrics being margin dollars and training materials that stress margin dollars and gross margin percent.
In other words, the knowledge brokers in the PHCCP channel are pushing the same 40-year-old knowledge that is as much of the problem as it is the solution. In a recent phone conversation with a “luminary” leader of a well-known buying group, I was told that “there was no need to slice and dice your business to understand what is profitable and what is not.” When I asked the “luminary” what he used to drive profitability he obfuscated something about margin dollars and expenses but never got to any detail. What I heard from this bastion of intellectual leadership was, “Don’t confuse me with the facts, my mind is made up!”
The upshot of this blog installment is that for distribution to get better, especially in a cost-sensitive environment, there needs to be a critical review of age-old concepts such as margin dollars, gross margin percent, and top line sales. These metrics, by themselves in an aggressive step cost business, don’t mean much and can, and often do, work against the ability to create a low-cost platform and highly profitable business.
My findings from the new knowledge mean that many of the arguments about sales compensation, pricing, and sales training are bunk. These concepts have little meaning unless they use metrics other than singular financial accounting conventions of margin dollars, margin percent, and top line sales. Much of the existing stuff is not worth the paper it is written on and why wholesalers flock to it year after year is beyond me.
As I said at the beginning of this piece, maybe I may have been in distribution too long. A few years ago, a friend of mine, a distribution exec of many years, left the industry with 15 years left in his professional career. He went into an entirely different field and is doing nicely. He once told me that, after two and a half decades in distribution, his concept of distribution profitability was rather simple. He told me, “Scott, you tell a dozen wholesalers that you will buy $100 worth of stuff from each of them to play a game. You then put the 12 in a room with Nerf bats, throw twenty-five dollars in pennies on the floor, and turn off the lights. You tell the wholesalers to wail on each other with the bats while trying to pick the money up off the floor. After a day of this, and after they are tuckered out, you turn on the lights and send them home with whatever they have collected.” I reflect often on this observation and why wholesalers don’t walk into the room with a spotlight and/or size 36 Louisville Slugger Ash bat is beyond me. If wholesalers want to work their keisters off for pennies on the dollar with antiquated knowledge then that’s their decision.
However, I advocate new knowledge and new tools for much better and much easier secured profits. I’m looking for knowledge leaders who will study and try the new concepts. I’ll even settle for a well thought out argument as to why the new stuff won’t work. Do I have any takers or would you rather play a little “baseball” if I bought $100 worth of stuff?