Productivity, or real gains in output per employee, is important for several reasons. First, businesses compete, in the long-run, by reducing costs and passing the savings on to the customer. A look at products over time finds most of them have decreased significantly as a percent of the homeowner’s paycheck. Second, productivity means that the business is applying capital to technology and processes to reduce cost and increase quality. Typically, as productivity increases, so does quality. Lastly, the best in class companies, those that win in mature markets, are low-cost producers.
Any industry where productivity is an issue is due for consistently low profits, inability to attract top managers because of salary caps, and an inability to reduce long-run prices to grow share. Gaining productivity through process management has long been a concern of distributors. Many wholesale firms have developed quality processes that document work flows, review bottlenecks, and reduce process costs. These efforts are all well and good but nonetheless our research shows lasting long-run productivity increases in distribution are non-existent.
Our contention is that productivity increases have been aimed at making the current processes more efficient, and this is where the problem exists. Our research finds that managing new business is where productivity gains are sustained, and that is the responsibility and domain of the outside sales force.
The Concept of Flow SalesSome five years ago, we began working with a new model of costing customer service costs. The discipline is named Labor Differential Transaction Costing (LDTC), and as we have improved the modeling and usage of the discipline, we have found that the current management and measurement systems using Financial Accounting are largely inadequate for long-run profit maximization, including long-run cost reduction. Some of our findings contrast greatly with the information gathered from financial accounting including:
Not all sales are profitable or desirable;
Margin dollars for an account are a poor predictor of that account’s
contribution to operating profit;
Measuring costs in time periods has very little to do with how the costs
fluctuate and what drives the cost (i.e., managers don’t manage time);
- Transaction size in margin dollars, mix of transactions and cost of transaction type are the key drivers of long-run profitability.
The upshot of our work is that most traditional measurement systems are invalid, such as rewarding sellers on margin dollars, for example. While distributors need financial accounting for cash flow management, paying taxes, and recording revenues and expenditures, as a means of maximizing long-run profit, the discipline is weak and this can be demonstrated in Exhibit 1, below, where we introduce the Concept of Flow Sales.
Flow sales are those sales that are part of the ongoing customer relationship and can be counted on to “flow” through at consistent intervals. The vast majority of distributor sales are flow sales, which are typically found in shipments of stock items. The service capacity to handle flow sales, in any time period, is depicted by the solid lines labeled capacity boundary-existing. Most distributors staff their capacity to handle flow sales with a buffer for peak demand periods.
The problem with flow sales is that the distributor sizes for the capacity after the sales are secured. There is no good way to gauge the service demands of new, incremental business. The metrics for landing new accounts, sales and margin dollars, have no real correlation with the service capacity needed to service them. In the words of one distributor, “I know forty percent of my accounts cost more to serve than they yield in margin dollars, the problem is I don’t know which forty percent.”
Gross margin dollars and top line sales for an account are very poor filters and, when new accounts are secured, capacity can quickly and easily become constrained. In the short-run, the distributor taps into overtime, which causes profits to fall significantly as overtime labor is 1.5 times normal labor costs. The capacity constraints and overtime costs are represented by the dashed lines labeled Capacity Boundaries - Existing Filters.
The problem with sales and margin dollar filters for new sales is that the distribution firm is always playing a cat and mouse game with capacity, where some two-thirds of operating costs are for people to process the orders. In some time periods, the firm is over capacity and, in others, it is under-capacitated and seeks overtime or new hires. Even though the firm may improve internal operations, these improvements can be easily wiped out with transaction-intensive new business as depicted at the far left in the Exhibit. The key to securing long-run cost reduction is in training sellers to profile new business with new metrics that ensure the business can be profitably served.
Transaction Profiling and Transaction Profit ManagementThe three main drivers of account transaction profitability are transaction size in margin dollars, type of transaction and its cost, and mix of transactions. Sellers need to be taught these principles and profile the transaction cost of a potential account, especially if it is of significant size, before it is secured in the firm. To understand the process of Transaction Profiling consider the distributor, let’s call them Big City Supply, with average costs and sales by transaction as follows:
Stock orders at $65, sales at $300;
Non-Stock orders at $110, sales at $250;
Counter sales at $45, sales at $75;
- Direct Shipments at $27, sales at $1,350.
A potential account, Diamond Construction, yields sales of $523,455 at a 20% margin. Big City’s sales rep on the account, Star Seller, sets sku pricing to come in at a 20% overall margin and secures the business. The problem is that Star Seller and Big City Supply are using sales and margin dollars as a filter. These metrics have very poor correlations with operating cost specific to an account. Consider that Diamond Construction’s transaction history is:
1100 stock orders
896 Non-stock orders
- 1078 Counter orders
Assuming an average margin of 20%, and order sizes at the current Big City average, we have the following costs for serving Diamond Construction of:
Stock orders of $71,500
Non-stock orders of $98,560
- Counter orders of $48,510
The total costs of service for Diamond Construction are $218,570 which, less margin dollars of $104,961, creates a loss of $113,609. Without properly profiling the account, Big City Supply is now having to add a significant amount of capacity to serve Diamond Construction.
The issue with Diamond Construction is all too common. Without profiling the account with proper filters, securing new business is often a losing proposition where the firm both adds capacity with overtime or new hires while concurrently robbing capacity from profitable customers to serve unprofitable ones.
In the case of Diamond Construction, Star Seller could have, if properly trained, made the following policy decisions before the first order shipped:
Miminum stock order size of $500;
Price non-stock orders at a minimum of 30% margin and charge a fee for special
- Develop a shop inventory or bin filling system for service vehicles and cut down on counter visits.
These steps would reduce service costs, drive up transaction size in margin dollars, mitigate costly orders, and service the customer better. Of course, getting Diamond Construction to understand that these steps would reduce their supply chain costs takes work on the part of Big City and Star Seller to map the costs and present them to the customer.
Without profiling transactions for Diamond Construction, Big City would lose significant money and have to hire additional capacity to process their orders. When the wholesale firm repeats this scenario many times, it is no wonder that long-term cost reduction efforts typically fail and distributors have flagging productivity.
The key element in being more productive is for the distributor to profile the transaction costs of the account before the first order is shipped. This starts with measuring accounts with transaction costs, teaching sellers about what drives transaction profits, and having a list of policy actions for new accounts that enables them to become a positive contributor to operating profit. Without these efforts and this understanding, distribution will have productivity issues that bedevil their ability to secure greater profits while simultaneously giving the customer a better buying proposition.