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Practical Solutions to Negative Profits in the Era of Cost to Serve

May 14, 2010
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In his recent book, Profit Myths in Wholesale Distribution, Al Bates lauds gross margin dollars as one of the most important numbers and concepts in running a profitable wholesale company. From a financial accounting perspective, where numbers are compiled in time periods, he is correct. If you don’t have enough margin dollars to float the bills and provide a reasonable profit, the business is not worth much. From a long-term perspective, however, and for managing profit at the account, segment, branch or sales territory level, margin dollars leave a lot to be desired.

The problem with margin dollars is that they can’t, in the traditional format of the income statement, tell distributors much about which accounts, territories and even in some cases branches contribute to operating profits. Recently, there has been a resurgence of interest in understanding which accounts, territories, etc., contribute to operating profits and which don’t. The nascent field has produced certain sound bites and terms that will become an enduring part of the distributor lexicon.

One of these terms, “cost to serve,” is getting air time with popular consultants. We began using the term back in 2004 with our seminars on cost management for various associations. In truth, there are articles, specific to wholesalers, citing service costs dating back to 1984. 

The primary issue with cost to serve is that the wholesale firm must have some type of method to allocate costs to accounts and other marketing and sales entities. Activity costing was the preferred model some years back but user interest has waned due to complexity and questionable information.

There are, as of today, two methods for allocation that avoid the complexity of yesteryear and adhere to the new rules of allocation: 1) a single baseline logic; and 2) applicable to the wholesale industry and easy to use. These models are Time Based Activity Costing offered by Acorn Systems and Differential Transaction Costing by Benfield Consulting. Other costing methodologies often fail the two rules cited above, invented by Robert Kaplan.

(For more on the differences in cost-to-serve models and myths, see our online article at: http://www.industrialsupplymagazine.com/pages/Management---Five-myths.php)

Assuming the distributor has a valid cost allocation logic, the challenge becomes how to manage the information. One of the popular lines is that giving outside sellers a load of cost-to-serve statistics, and changing sales compensation to reward cost-to-serve profits, is the way to profitable accounts. Our work in Differential Transaction Costing Management finds that giving outside sellers cost-to-serve statistics and changing their compensation to reward on cost-to-serve profits is, generally, a bad idea.

Managing and Planning vs. A Bunch of Numbers

Our research and history show that traditional compensation models that reward heavily on margin dollars are, largely, a bust.

Why? Valid cost-to-serve models find that some 40% of sales territories are profit negative. In essence, gross margin dollars don’t include cost-to-serve analyses and hence, the number is a crude tool in managing operating profit. And, it really doesn’t matter whether the compensation system is bonus and salary, commission and salary, straight commission, or some hybrid combination structure. As long as the system uses margin dollars to determine a significant part of compensation, the result is that there is scant correlation between this measurement and operating profits at the territory and account level.

Enterprising knowledge brokers have tapped into this fact and have come up with new cost-to-serve models and services. These are quick to recommend changes to compensation and sellers being brought up to speed on cost-to-serve statistics and strategies. In our opinion, distribution is an industry inebriated with sales solutions. New methods based on sales to fix profitability amounts to passing the bottle to the habitual drinker.

We have seen sales-driven tactics include pricing so complex and incoherent that it rendered the cure worse than the disease. We have seen customized service solutions that caused operating costs to balloon and service errors to rise. 

Our work finds that changes to compensation using cost-to-serve statistics and giving sellers new numbers is largely ineffective for profit solutions unless they are preceded by proper planning in marketing and operations before sellers are given a bunch of numbers.

Common solutions that we recommend to clients where cost-to-serve numbers are negative include segmented pricing, service rationalization, fee-based services, and streamlining services. 

In essence, when engaging cost-to-serve logic, it behooves management to develop pricing, services, and cost restructuring prior to rolling out any of the data to sellers. Properly developed and vetted solutions at the corporate level prevent sellers from offering customized solutions that, too often, cause operating costs and errors to rise, which defeats the purpose of engaging the discipline in the first place.

Our advice before engaging any cost-to-serve logic is to research the literature and ask the following questions:
    1) Does the cost-to-serve allocation logic adhere to the principles set out in Kaplan’s research, i.e., one baseline logic and easy to use in the terminology of the business?
    2) Does your firm have the proper understanding and ability to plan solutions around operations and pricing at the segment level?
    3) Does your firm have the proper controls and review process to implement common cost-to-serve solutions?

If you can’t answer or don’t understand why these questions are important, we suggest not getting involved in the new knowledge. Otherwise, we are confident that you will be easy targets for costing models that don’t work, and you will end up disappointed and disillusioned.

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