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Breaking and Reforming the Value Chain for a Better Value Proposition

July 1, 2009
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Seven years ago, I made a presentation to a well known distribution research board1 on two related subjects called Transactional Distribution and Quantifying and Adjusting Service Value. The presentation followed several years of discovery of alternate models of distribution that took the cost out of traditional wholesaling and gave the customer a much better price. The presentation had an element of service research in it also and reviewing service costs and how they intermingled to provide a value proposition to the customer.

The presentation and Q&A lasted less than an hour. The board, a composition of wholesalers, industry association representatives and national association personnel listened intently and asked questions. Several days later, I got a call from the board representative. They wanted to pursue the service portion of the project but not the transactional distribution portion. I was more interested in transactional distribution, however, and decided that it would be better to forego the project. I also heard back from some friends, who were board members, that there was a lively discussion regarding transactional distribution. The discussion and objection was that transactional distribution challenged the basic value proposition of merchant wholesalers. It basically held that less value was more value for many customers and distributors would need to challenge their traditional value bundles. My friends told me that the biggest objectors were the distributor association representatives and not the distributors. 

These days, most distributors are acutely aware that the traditional value bundles will need reformation. Transactional distribution and the concepts surrounding it are looking better all the time. The Great Recession and ensuing forecast for a protracted correction have all but ensured the need to review the established model of business. Most wholesalers know that yesterday’s Shangri-la of runaway commodity inflation and 3% GDP growth was, in large part, an anomaly. The economy of 2003-2008 was part sham, part speculation, and part luck and we won’t see its equal for some time. 

Instead, we are in a slow growth economy where the excessive debt and credit binge of the past won’t fuel growth. Instead, the fuel for growth will be a lower cost for the customer, hence, the need for transactional distribution and how to get the long run cost out of the current model is both timely and assured.


The Problem With Value

There has been, in recent business literature of the last decade, the concept of value added in the supply chain. In essence, each point of the supply chain, from manufacturer, to wholesaler, to wholesaler customer adds value. There have even been attempts to map value across the chain and quantify the value added by different channel members and their functions. Most, but not all, of the research and articles about value have some fundamental assumptions including:
 
  • They assume the current model of business can be perpetuated into the future with incremental changes. This so called “incrementalism” often believes that the current model, with changes in streamlining functions, reducing variation in process while lowering error and driving low cost will perpetuate the firm into the future.
     
  • They assume that the current players in the value added equation will be the future players. In essence, if Old Fashioned Supply, sells king widgets today, they will sell king widgets tomorrow. They assume that the current manufacturing base of vendors will be the same.
     
  • They assume that the current functions including outside sales, inside sales, sales promotion, and local branches will be value added in the future.


    This was, I think, the problem many years ago with my presentation to the distribution research board. The model(s) of business I went over and my proposed research didn’t necessarily make these assumptions and the changes were disruptive and controversial. Few people, seven years ago, really wanted or needed to consider highly disruptive channel structures. Today, however, the economic environment and technology advances have created a scenario where new channel structures will appear and many will dominate.


  • The Change Is All Around Us, But Not Among Us

    There was a recent online article that listed the businesses that are in trouble or long in the tooth. They included such names as Blockbuster, Playboy, Borders, Macy’s, Bed, Bath and Beyond, Office Depot and other companies who have recognizable names. The problem with these business models is that they are old and costly. You can get their products on the internet and have them shipped immediately or within a few days to your home or place of business. You don’t have to leave home and shop their wares and their costs are very competitive. You don’t need all the brick and mortar outlets, salespeople, and “value added” services to help you decide which products to buy. In essence, if you know what you want, you can place the order online, enter a credit card, and wait for your order to arrive.

    A decade ago when e-commerce was the craze and Wall Street built a big bubble around these companies, many old line industrial firms, including wholesalers, laughed when the bubble burst. I was one of those naysayers as I remember turning down numerous “tech” companies who promised me millions in top line sales with a new e-commerce site. Today, many wholesalers have e-commerce sites but they are a complement for the existing model of business. Traditional wholesalers, for the most part, don’t see e-commerce as both catalyst and component for new transactional models of commerce. 

    However, I firmly believe that there will be new models of distribution that will heavily utilize e-commerce and other technologies to drive lower costs through the channel. And these lower costs will translate to new and better value propositions for customers. We are surrounded by the evidence of new and different channels in the retail markets of today. To think that similar structures won’t exist or can’t exist in durable goods wholesale channels is, in my thinking, naive and retrograde. Too many wholesalers and manufacturers are justifying their future while glorifying their history. I think many will be disappointed and much poorer because of it. 

    What Does a New Model Look Like? And Why Don't I see More of Them?

    When I talk about low cost, e-commerce, and streamlined global supply chains most wholesalers get my drift. They understand the concept but file it away in memory and go back to business as usual. They ask “if these models are so lucrative why don’t we see more of them?” My comment is that they are out there, still small in many markets, and that distribution is a very slow-to-change business. I end up giving several examples of these models including:
     
  • A 25 million dollar distributor that sells self-contained, technical products to a well identified contractor segment via a Web site. The site’s content is “produced” by manufacturers and the e-commerce capability is programmed by the “distributor.” The distributor stocks nothing. They maintain the site and have a few technical specialists in an office building. They place 15 percent margin on the products they sell, ship them direct from the manufacturer(s), and provide technical support as needed. Last time I talked to them, about a year ago, they were growing at 20% per year and had operating profit of 10% of sales. They underpriced the competition, traditional HVAC distributors, by 20% or more.
     
  • A billion plus dollar distributor of repair parts who drives transactional economics through their customer base. They link discounts to order size, demand annual order volumes for discounts on key products, and cover minimum order costs by linking full freight allowed to a minimum order size. They don’t go in for a lot of frilly marketing and sales promotion and they are aggressive in going after larger stock orders. They are very particular in stocking the high sales and high margin products. This company recently put one of their competitors, a former full service distributor, on the ropes. 
     
  • An import/distribution company that sells commodities to wholesalers. They buy the stuff in container loads, make sure it meets code and various building specifications and has a modicum of literature and customer service support. They then sell container or half-container loads at prices that are way below that of domestic brands. They offer highly selective or exclusive territories. When you sign on, you plan the annual volume of product you will buy from them and agree to container or half-container loads. When you order, you do so online. 


    These models are an example I’ve run across in the last few years and they have several things in common including:
    • They have few sales costs. They offer customer service support but basically don’t have much in the way of a full outside and inside sales effort. They may have some select outside sellers but, again, a big outside sales force could be counted on two hands.
       
    • They don’t do much in the way of marketing and sales promotion. They don’t offer a lot of sales promotion programs, they seldom pay marketing groups or buying groups 5% to be a preferred vendor, they seldom attend industry events or whoop it up at association events. In essence, a lot of the frills, boondoggles, and so-called “relationship” marketing and selling is kaput. 
       
    • They all have e-commerce models that are functional, full of content, and easy to use.

    • They have technical support but utilize online technical support wherever possible.
       
    • They source from quality vendors, meet spec, and have sufficient insurance for product liability issues.
       
    • They have minimal brick and mortal locations.

    • They drive transaction economics of transaction size, transaction type, and transaction mix.2
       
    • They tap into global supply chains and search for the best global value of price and service.

    • As much as possible, they control the flow of information and brand identity to the customer.
     
    All of these entities, as far as I have been able to obtain, have profits that are 4 to 5 times greater than traditional distributors. In essence, their operating profits are 10% or more of sales and their returns on equity are, in most instances, over 30%. They also offer prices that are 10% to 30% less than traditional competitors.

    Getting a Grip on the New Way of Doing Things

    I don’t expect any of these new models of business to, in the near term, drive out traditional channel members. Over time, however, I do believe that they will cherry pick the best parts of the supply chain and leave full service distributors the less lucrative parts of the business. I don’t really expect most existing distributors to develop these models; there are simply too many people that believe in “incrementalizing” their existing business. There are way too many distributors who will try to cut costs in the traditional model, hunker down, and hope things will get better. They are much more optimistic than I am. I do expect that a few will get a grip on the new ways of doing things, develop the models, take them to market and make lots of money.  


    Footnotes:
    1
    The research board has since changed its name and altered its mission. 
    2 Benfield,S., Griffith S, “Why is Wholesale Distribution a Low Profit Business?”, White Paper by Benfield Consulting, November 2008, pg. 5, at www.benfieldconsulting.com.

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    A better value proposition

    Gerry Couch
    July 6, 2009
    The key to your supposition is that buyer is expert enough to make choices with limited contact from seller. We are in distribution business of Capital equipment that has a important service and support contingent. If buyer makes choices primarily on price and assumes all machines are generic, including service and support , he is going to be dissapointed in his operating cost. So while I agree on "replacement parts" part of our business this is applicable, I don't think this will work on purchase of Machines. Do you think there is a basis on which it will work in Industrial Forklifts or Construction Equipment?

    Forklift-Reduced Cost Model

    Scott Benfield
    July 6, 2009
    Mr. Couch: You are correct in stating that some businesses are more complex than others and will ammend themselves to cost out strategies more than others. However, even in capital equipment, there are some parts of the business where the customer knows what they want, product attributes are limited, and ordering online is all that is really needed. If these attributes exist in part of the material handling vertical market, then I would say that it is ripe for a transactional model. If the customer knows the parts they want and traditional distributors are tacking alot of excess costs and no value "value addeds" on to that part of the business, then there is a possibility that the service platform can be arranged to give a lower cost to the customer. Give me a cull if you want to discuss further. (630) 428-9311

    A Better Value Proposition

    Robert Shimmin
    July 6, 2009
    In your examples it appears the distributors are just transferring costs elsewhere - direct shipments from manufacturers, transfer of small orders to competitors and limited customer communications. While limited communication may work for some customers, what's in it for the manufacturer?

    A Better Value Proposition

    Scott Benfield
    July 7, 2009
    Mr. Shimmin: You have made a good insight. Based on Differential Costing analyses of channels, (see Transaction Management White Paper at benfieldconsulting.com) much of the transactions performed by distributors have, historically, not made money. Furthermore, the less labor intensive transactions of direct shipments and stock (original orders) are really the key money making transactions in the industrial/B2B channel. On top of this, without year end manufacturer rebates, many distributors would be insolvent (or close to it). In my estimation, manufacturer's dollars in rebates, association meetings, special pricing, etc. have helped mask the issue. And the issue is that current channel structures are not all that profitable and because of technology and the business cycle, are becoming unsustainable. Throw in the influx of foreign off brands at 30% less than domestic brands and manufacturers have real challenges. (Note: We tested this and wrote a book on it 18 months ago called Disruption In the Channel-see our site.) My guess is that the distributors that change to new models will use key manufacturers but will demand EDLGP (Everyday Low Global Price) and top notch service. Also, many manufacturer channel supports will have to go including co-op programs, sales promotion, excess marketing, association events, etc. We did research on sixteen manufacturer services two years ago and found domestic brands were investing in services that were of low importance while foreign brands performed basic services that were of high importance. Beyond this, existing distributors who don't change and don't develop global supply chains, will demand even more concessions from manufacturers. In summation, domestic manufacturers who have not examined their channel supports, challenged them and trimmed back the less important ones will be in trouble. Also, domestic brands that have not taken a close look at foreign off-brands and their channels may be in for a big surprise as these brands average 30% less in cost. What's in it for the manufacturer? In summation, for the incumbent domestic manufacturer, a significant share loss is probable if they haven't reviewed the issues raised in the body of this reply. Scott Benfield

    Amazon.com

    Ron Gilstrap
    July 13, 2009
    Interesting article and fundamentally, makes sense. The case of Amazon.com's initial years of existence provides a 180 degree view of the e-commerce model removing traditional distribution. Amazon started with exactly the model you discuss and drop shipped books from various publishers. Over time the model didn't produce the longer-term results needed and they moved to establish their own warehouse(s) and now receive books from the publishers into their stock, for resale. Any comments on this?

    Amazon Same and Different

    Scott Benfield
    July 13, 2009
    Mr. Gilstrap: The model you mention at Amazon was tried in the early days. They, Bezos and Co., thought they could drop ship most of their inventory and found out that dealing with numerous publishers was a hassle, lead times were long, and the customer wasn't all that thrilled with the varieties of service. So, they started warehousing. Transactional distribution isn't about one transaction type even though drop shipments make a significant amount of the operating profit for distributors. Remember also that stock (original orders) also make significant profit for the distributor. The problem is that, in aggregate, non-stock, counter sales, and back-orders often are net losers. It's important too understand the qualifier "in aggregate." Some non-stock orders, counter orders, etc. do make money. The larger sales and higher profit orders in these categories can contribute to operating profit. The problem is that most wholesalers can't accurately measure this and don't put limits on these transaction types to mitigate their loss on them. Outside of transactions and their costs, I do expect e-commerce combined with Differential Costing and Transaction Management to offer a stripped down model of distribution to become more common in the next decade. There is simply too much cost in the current distribution model and end customers won't pay for excess costs of any kind. I would suggest you read the White Paper, Transaction Management, on my site at benfieldconsulting.com. It's on the home page of the site and, after that, if you want to talk more, give me a call. Scott Benfield (630) 428-9311

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