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Right Structuring vs. Right Sizing: Growing Profits for the Coming Decade

June 28, 2010
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It should be plain by now that the downturn that started two years ago is far more than a typical recession. The North American and European economies are victims of two decades of over-borrowing, over-spending, and investing in asset bubbles. The Western economies are now awash in debt. Austerity measures, the norm in the Eurozone, will need to be embraced by the U.S. or worse economic times await in the decades ahead.

Also, the specter of increased taxes haunts the political establishment. Increasingly, many long-term forecasts believe that taxation will need to increase as well as undergo significant reform.  Our belief is that spending cuts, outsourcing state and federal work to the private sector and decreased taxation is a better answer. But the catch-22 is that the politicians who are needed to enact the changes can’t or won’t do so without fear of losing their constituency. These macro-economic issues will greatly affect distributors for the balance of this decade.

Two years after the downturn started, it appears that the economy is on the verge of a double-dip recession. Recent housing sales, unemployment, and retail sales figures point to demand that is slowing for the second half of the year. Inflation, the talk of post-recession forecasters, looks further away. The recent Federal Reserve meeting lowered interest rates and forecasted lower inflation. The bigger problem now looks to be deflation, which is primarily the effect of sagging demand.

As leveraged borrowers pay down debt, their consumption goes south and everything suffers. Prices fall, inventory values decline or are stagnant and distributors that experienced inventory profits a few years back are now left with “vapor” profitability. The typical response is to cut as many expenses as you can and hunker down.

Most distributors have done this and earnings are in the tank. Normally, wholesale industries average between 2% to 3% of sales in operating profit. For many industries, this number has slipped well below 2%, which, according to our research, from a long-term investment perspective, isn’t worth it.

The questions that we are posing to distributors, and to which we get not-so-good answers, are how and what will you need to change to compete in a decade of nominal growth and deflation? Most distributors point to right sizing and hunkering down. But they can only right size and hunker down so long before atrophy sets in and they lose touch with the market. Over time, too much right sizing leads to an inability to grow, with customers often realizing this before management does. Hence, customers begin to trickle away, which only makes the problem worse.

Our view is that right-sizing may get you through the short-term recessionary environment but will ruin your firm in a protracted recovery dogged by deflation. Our work says that distributors will need to right structure the firm, which means that business as usual won’t work all that well. The firms that grow in the next decade, who avoid atrophy, will do things much differently and will need new knowledge and tools to do so.

Too Much After Too Little

In explaining the preceding macro issues to a wholesale client, I used the simile of the high-school chemistry lab beaker. The beaker has a long neck and large triangular bottom. The top of the beaker represents the number of customers who drove operating income. They are small in number but are at the top of the operating profit pile.

The bottom of the beaker, where most of the customers are, drags down profits. Distributors spend far too much of their effort, expenses, and time on the bottom half of the beaker that loses money while funding it from the neck of the receptacle where a small portion of customers dominate.

Furthermore, distributor measurements, reward systems, and thought processes are generated to grow the bottom half of the beaker and not the top half. To exacerbate this undesirable situation, hunkering down and trimming service capacity often robs capacity from the best customers to service the profit draining ones. Cutting expenses, without a thorough understanding of where they are generated, reduces service to those willing to pay for it.

The core problem with managing the distribution firm in these economic times is that traditional accounting is a crude tool. Distributors think of making profit in linear terms and as long as margins exceed expenses, things are headed in the right direction. But this type of thinking is all wrong. Gross margin percent and gross margin dollars are crude tools for maximizing profit and understanding which sales and marketing entities are good investments.

Why? Distribution is a razor thin profit business, and expenses aren’t in line with profit production. The profitability seen on the income statement is as much fiction as it is fact. When operating expenses are fairly allocated to customers, segments, branches and transactions, where operating profits are made becomes clear and it is anything but linear.

To know this, distributors must adopt fair and useful allocations of operating expenses to marketing and sales entities. They also must begin to change their thinking on what drives the business and where, in slow to no growth times, they need to invest precious capital. Without this knowledge, they are left in the world of cut expenses broadly and hunker down. Their profitability atrophies and they become the ward of vendor programs or buying groups relying on declining rebates for solvency.

Plugging the Holes in the Ship

In my early years, I would canoe the whitewater rapids of the southern Appalachians. I quit not long after crossing a Class IV rapid where a protruding log punched a hole in the canoe and the incoming water overran us. My right leg was pinned between the waterlogged craft and a rock. Somehow I freed myself and floated to shore. I had severe contusions and was on crutches for six weeks. I learned many lessons from the event, one of which is that as the flow increases rapidly downhill, one should plug the holes as quickly as possible or the craft will sink and often more quickly than expected.

Distributors have many profit leaks and as sales fall, they need to plug the holes to navigate rough waters. The problem is that most distributors, using traditional accounting measures, have a very poor understanding of where the leaks are. 

Consider our findings after five years of allocating expenses to transaction types and then assigning them to customers, branches, and sales territories.  
  • Forty percent of sales territories don’t yield an operating profit. In essence, forty percent of the time, management pays the seller without a positive contribution to operating income.
  • Rewarding sales bonuses on commissions on margin dollars has an almost even chance of delivering negative profit accounts. Margin dollars, without matching expenses, don’t mean much and rewarding sellers on them often drives profit destruction.
  • Most non-stock sales and branch transfers, in aggregate, are profit losers. Branch transfers cost somewhere in the range of 15% to 25% more to process than an original stock order and most don’t fetch a higher price to pay for the added processing cost.
  • Most distributor fleets are grossly inefficient for small transactions. Contracted carriers such as UPS can deliver small transactions for significantly less cost than what distributors can. 
  • It is almost impossible to tell if a branch makes money by allocating home office expenses based on sales or margin dollars. The proportion of branch sales or margin dollars to the corporate whole has little to do with how the branch consumes corporate expenses.
 

This is only a partial list of the profit leaks that bedevil distributors. Again, the culprit is that current financial tools and reward systems do almost as much to destroy profit as they do to encourage it.

A final and fitting analogy of leaking profits is the experience of James Cook, the British mariner and explorer of the South Seas in the 1700s. When stopping in the Hawaiian Islands, Cook encouraged his sailors to take shore leave and enjoy the company of the Polynesian women. This encouragement waned, however, when he learned that his crew was pulling the malleable iron nails out of the ship boards to pay for sex, as metal was a treasured commodity for the Polynesian men. Cook was out to sea and in a storm when his ships began leaking and he learned the awful truth. He had to return to the Islands and bribe the natives for the lost fasteners.

Rewarding sellers on margin dollars has the same effect as nails for the natives. Sellers, compensated on margin dollars, give away operating capacity to those who can’t afford to pay for it and the profit leaks away while the ship is out to sea. Eventually, the few customers who pay for everything discover their service offering is short and they leave. Distributor management then has to bribe them back with price decreases and greater service.

Right Structuring

Moving away from financial measures and controls is a big change. Distributors don’t wholly buy the logic of allocating expenses to customers, transactions, branches, sellers and market segments. They have been relatively prosperous with existing financial measures.

The coming decade, however, poses unique issues. The changes required to compete in a slow growth, price sensitive, deflationary environment are largely structural and big in scope. We call adapting to this environment “right structuring,” and it is quite different than right sizing. Right sizing is incremental improvement, which is fine for normal times. These are not normal times and “incrementalizing,” in a changed environment, often does more harm than good. The problem with incremental improvements or best practices is that they only work when the outside environment is predictable and familiar. Major shocks to the operating environment need new thinking and new methods.

Many, perhaps most distributors, don’t recognize the limitations and profit destructing potential of financial accounting metrics and its use. Our experience and forecast of the future environment predicts that they will regret not using new knowledge and new metrics. Of course, by the time one knows if our prediction is on target, the sellers may have given away all the nails and the ship sinks while weathering the storm.

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